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Subtopic
Leadership Skills

Topic

Professional

Critical Business Skills
for Success

Course Guidebook

Professors Thomas J. Goldsby, Ryan Hamilton
Clinton O. Longenecker, Michael A. Roberto,
and Eric Sussman

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Michael A. Roberto, D.B.A.

Trustee Professor of Management
Bryant University

essor, Critical Business Skills: Strategy

rofessor Michael A. Roberto is the Trustee
Professor of Management at Bryant
University in Smithfield, Rhode Island,
he has taught since 2006. Before joining
Bryant, Professor Roberto served as a faculty
member at Harvard Business School and as a visiting professor at New
York University. He earned a bachelor’s degree in Economics from Harvard
College, as well as an M.B.A. with high distinction and a doctorate in
Business Administration from Harvard Business School.

Professor Roberto’s research focuses on organizational and team decision¬
making processes. He has focused extensively on the decision-making
breakdowns that lead to large-scale organizational failures. His next book
will focus on the challenges that established organizations face as they
try to embrace the design thinking approach to creative problem solving
and innovation.

The M.B.A. students at Bryant University have chosen Professor Roberto
for the Excellence in Teaching Award on eight occasions. He also earned
the Allyn Young Prize for Teaching at Harvard on two occasions. Professor
Roberto’s innovations in teaching with technology have earned several
major awards. The Everest Leadership and Team Simulation won top prize
in the eLearning category at the 16 th Annual MITX Interactive Awards.
This competition recognizes achievements in the creation of web and
mobile innovations and emerging applications produced and developed in
New England. Professor Roberto’s multimedia case study about the 2003
space shuttle accident, titled Columbia s Final Mission , earned the software
industry’s prestigious CODiE Award in 2006.

Professor Roberto is the author of two books: Why Great Leaders Don ’1
Take Yes for an Answer: Managing for Conflict and Consensus and Know
What You Don’t Know: How Great Leaders Prevent Problems before They
Happen. He has published articles in the Harvard Business Review , MIT
Sloan Management Review, and California Management Review. Professor
Roberto also has taught two previous Great Courses: The Art of Critical
Decision Making and Transformational Leadership: How Leaders Change
Teams, Companies, and Organizations. ■

Thomas J. Goldsby, Ph.D.

Harry T. Mangurian Jr. Foundation Professor
of Business and Professor of Logistics
The Ohio State University,

Fisher College of Business

Professor, Critical Business Skills: Operations

P rofessor Thomas J. Goldsby is the Harry
T. Mangurian Jr. Foundation Professor of
Business and Professor of Logistics at The
Ohio State University’s Fisher College of Business. He has held previous
faculty appointments at the University of Kentucky, The Ohio State
University, and Iowa State University. Professor Goldsby holds a B.S. in
Business Administration from the University of Evansville, an M.B.A. from
the University of Kentucky, and a Ph.D. in Marketing and Logistics from
Michigan State University.

Professor Goldsby is coeditor in chief of Transportation Journal , the oldest
academic journal in the field of business logistics; coeditor in chief elect
of the Journal of Business Logistics, and co-executive editor of Logistics
Quarterly magazine. He also serves as associate director of the Center for
Operational Excellence, a research fellow of the National Center for the
Middle Market, and a research associate of the Global Supply Chain Forum,
all housed at Ohio State’s Fisher College of Business. His research interests
include logistics strategy, supply chain integration, and the theory and
practice of lean and agile supply chain strategies.

Professor Goldsby has published more than 50 articles in academic and
professional journals. He is recognized as one of the most productive
researchers in the field of logistics management. Professor Goldsby is a
recipient of the Best Paper Award at the Transportation Journal (2012-
2013) and the Bernard J. LaLonde Award at the Journal of Business
Logistics (2007). In addition, he has twice received the Accenture Award for
Best Paper published in The International Journal of Logistics Management
(1998 and 2002). He has received recognition for excellence in teaching

iii

at Iowa State University, The Ohio State University, and the University of
Kentucky. Professor Goldsby has supervised more than 100 Lean/Six Sigma
supply chain projects with industry partners; chaired six Ph.D. dissertations;
and served as an investigator on five federally funded research projects,
exceeding $2 million in grant proceeds. He has fulfilled visiting professor
assignments at the Politecnico di Milano (Italy), WHU-Otto Beisheim
School of Management (Germany), and the Copenhagen Business School
(Denmark).

Professor Goldsby is the coauthor of four books: The Design and
Management of Sustainable Supply Chains', The Definitive Guide to
Transportation: Principles, Strategies, and Decisions for the Effective Flow
of Goods and Services', Global Macrotrends and Their Impact on Supply
Chain Management: Strategies for Gaining Competitive Advantage', and
Lean Six Sigma Logistics: Strategic Development to Operational Success.
Professor Goldsby is a member of the selection committees for several
industry awards, including Gartner’s Supply Chain Top 25, the Council of
Supply Chain Management Professionals’ Supply Chain Innovation Award,
Logistics Quarterly's Sustainability Study and Awards Program, and the
University of Kentucky’s Corporate Sustainability Awards. ■

Eric Sussman, M.B.A.

Senior Lecturer, Accounting and Real Estate
University of California, Los Angeles,
Anderson School of Management

Professor, Critical Business Skills:
Finance and Accounting

P rofessor Eric Sussman is a Senior Lecturer in
Accounting and Real Estate at the University
of California, Los Angeles (UCLA),
Anderson School of Management, where he has taught since 1995. He
received his M.B.A. from Stanford University with honors in 1993, after
graduating summa cum laude from UCLA in 1987. He is a licensed CPA in
the state of California.

Professor Sussman has received 13 Teaching Excellence Awards, voted on
by Anderson’s M.B.A. students, as well as the Citibank Teaching Award
and the Neidorf “Decade” Teaching Award, both voted on by a committee
of faculty members. In 2011, Bloomberg Businessweek recognized him
as one of the 10 Most Popular Profs at Top Business Schools, and he has
been named one of the 20 Most Influential Business Professors Alive Today
by Top Business Degrees, a website devoted to business school rankings.
In addition, Professor Sussman has advised numerous full-time and fully
employed M.B.A. field study teams and has led student travel groups
to Brazil, China, Dubai, Saudi Arabia, and Abu Dhabi. He teaches cost/
managerial accounting, financial accounting (beginning through advanced),
financial statement analysis, equity valuation, corporate financial reporting,
and real estate investment and finance to undergraduate, graduate, and
executive education students.

Professor Sussman has consulted for large and small firms, nationally
and globally, and is a frequent lecturer on varied topics in financial,
accounting, and corporate reporting. In addition, he created Insight FSA,
an analytical software tool that automatically measures, evaluates, and
reports on the financial accounting and corporate reporting risk for all

public companies via EDGAR Online. He also has served as an expert
witness and consultant for commercial litigation involving matters of
corporate financial reporting and disclosure, audit effectiveness, valuation,
real estate due diligence and related practices, and overall damage analyses.

Professor Sussman is President of Amber Capital, Inc.; Manager of Fountain
Management, LLC, and Clear Capital, LLC; and Managing Partner of
Sequoia Real Estate Partners, LLC, and the Pacific Value Opportunities
Funds, which have acquired, rehabilitated, developed, and managed
more than 2 million square feet of residential and commercial real estate
in the past 20 years. The firms’ portfolio currently consists of industrial,
multifamily residential, single-family residential, and retail properties.

He is Chairman of the Board of Trustees of Causeway Capital Management’s
group of funds (which collectively have in excess of $6 billion in assets); sits
on the Board of Directors of Pacific Charter School Development and
Bentley Forbes Group, LLC; and is former Chairman of the Presidio Fund
and former Audit Committee Chair of Atlantic Inertial Systems, Inc., a
producer and manufacturer of electromagnetic sensors. ■

Clinton O. Longenecker, Ph.D.

Stranahan Professor of Leadership and
Organizational Excellence
Distinguished University Professor
The University of Toledo, College of Business
and Innovation

Professor, Critical Business Skills:
Organizational Behavior

P rofessor Clinton O. Longenecker is a Distinguished University
Professor and the Stranahan Professor of Leadership and
Organizational Excellence in the College of Business and Innovation
at The University of Toledo, where he has taught since 1984. He holds a
B.B.A. in Marketing and an M.B.A. in Management from The University
of Toledo, as well as a Ph.D. in Management from The Pennsylvania State
University. Professor Longenecker also has served as a Visiting Lecturer at
The University of the West Indies at Cave Hill, Barbados, and has lectured
extensively in Poland, Hungary, and Russia.

Professor Longenecker’s teaching, research, and consulting interests are
in high-performance leadership and the creation of great organizations.
He has published more than 180 articles and papers in leading academic
and professional journals, including the MIT Sloan Management Review,
Industrial Management, Business Horizons, The European Business Review,
Organizational Dynamics, and others. He is a frequent media source, and
his research has been featured in The Wall Street Journal and Investor’s
Business Daily, on MSNBC and NPR, and in a wide variety of other outlets.

Professor Longenecker is an active management consultant, educator, and
executive coach. His clients represent a broad range of Fortune 500 firms and
entrepreneurial organizations, including Harley-Davidson, ConAgra Foods,
the SSOE Group, ProMedica Health Systems, Whirlpool Corporation, Eaton
Corporation, Cooper Tire & Rubber Company, Dana Holding Corporation,
the Howard Hughes Medical Institute, and 0-1, Inc., among others. Professor

vii

Longenecker has been described by Career Publications as “one of the top
motivational speakers in the U.S. who can blend cutting edge research,
common sense, humor and conviction into a real and inspiring call for better
performance that can help us all!”

Professor Longenecker has received more than 40 outstanding teaching,
service, and research awards and is the only professor in the history of
The University of Toledo to have been the recipient of the university’s
Outstanding Teacher, Outstanding Researcher, and Outstanding Service
awards. In addition, he has received numerous industry awards, including the
Ernst & Young Entrepreneur of the Year Award, a Toastmasters International
Leadership Award, and a Jefferson Award for outstanding public service. He
has been recently recognized by The Economist as one of the top 15 business
professors in the world.

Professor Longenecker’s best-selling book, Getting Results: Five Absolutes
for Fligh Performance (coauthored with Jack Simonetti), describes the best
practices of more than 2,000 high-performance managers and how they
achieve outstanding performance; the book has been translated into nine
languages. His latest book is The Two-Minute Drill: Lessons for Rapid
Organizational Improvement from America s Greatest Game, published
with Greg Papp and Tim Stansfield. The book chronicles the keys to rapid
performance improvement from the authors’ research on more than 1,000
organizational improvement initiatives. Professor Longenecker is also
featured in a number of educational videos, including the award-winning
CRM training film Effective Performance Appraisal and Continuous
Improvement in Manufacturing, based on his research.

Professor Longenecker is an active community servant and a Bible study
leader and Christian speaker. He has spent extensive time working in
the country of Haiti, managing several missionary schools and hospital
construction projects. He is happily married to the former Cindy Breese and
has three children. ■

viii

P rofessor Ryan Hamilton is an Associate
Professor of Marketing at Emory
University’s Goizueta Business School,
where he has taught since 2008. He received his
Ph.D. in Marketing from Northwestern University’s
Kellogg School of Management. He also has a B.S. in Applied Physics from
Brigham Young University, where he participated in proton-induced X-ray
emission research using a Van de Graaff proton accelerator.

Ryan Hamilton, Ph.D.

Associate Professor of Marketing
Emory University, Goizueta Business School

Professor, Critical Business Skills: Marketing

Professor Hamilton is a consumer psychologist, whose research investigates
shopper decision making: how brands, prices, and choice architecture
influence decision making at the point of purchase. His research generally
fits within the school of behavioral decision theory, examining how
contextual factors produce decision biases and irregularities. In 2013, he
was recognized by the Marketing Science Institute as being among the most
productive young scholars in his field.

Professor Hamilton has received multiple teaching excellence awards from
his M.B.A. students at Emory and, in 2011, was named one of “The World’s
Best 40 B-School Profs under the Age of 40” by Poets & Quants, an online
magazine that covers the world of M.B.A. education.

Professor Hamilton’s research findings have been published in some
of the most prestigious peer-reviewed journals in marketing and
management, including the Journal of Consumer Research, the Journal of
Marketing Research , the Journal of Marketing, Management Science, and
Organizational Behavior and Human Decision Processes. His findings also
have found an audience in the popular press, having been covered by The
New York Times, The Wall Street Journal, TIME, USA TODAY, The Financial
Times, New York magazine, and CNN Headline News.

Professor Hamilton is the proud father of five young children, which means
that he spends much of his time exhausted and slightly rumpled. He is also
a former amateur sketch and stand-up comedian and performed in that
capacity in clubs and on college campuses across the country. ■

Table of Contents

INTRODUCTION

Professor Biographies.i

LECTURE GUIDES

Critical Business Skills: Strategy

Scope.1

LECTURE 1

Strategy Is Making Choices.3

LECTURE 2

How Apple Raises Competitive Barriers.10

LECTURE 3

The Danger of Straddling.17

LECTURE 4

What Trader Joe’s Doesn’t Do.24

LECTURE 5

First Movers versus Fast Followers.31

LECTURE 6

When Netflix Met Blockbuster.38

LECTURE 7

Anticipating Your Rival’s Response.44

LECTURE 8

Why Did Disney Buy Pixar?.51

Table of Contents

LECTURE 9

The Diversification Discount.58

LECTURE 10

Forward and Backward Integration.65

LECTURE 11

Mergers and Acquisitions—The Winner’s Curse.72

LECTURE 12

Launching a Lean Start-Up.79

Critical Business Skills: Operations

Scope.89

LECTURE 13

The Power of Superior Operations.91

LECTURE 14

Leaner, Meaner Production.98

LECTURE 15

Refining Service Operations.106

LECTURE 16

Matching Supply and Demand.114

LECTURE 17

Rightsizing Inventory.122

LECTURE 18

Managing Supply and Suppliers.129

LECTURE 19

The Long Reach of Logistics.136

xii

Table of Contents

LECTURE 20

Rethinking Your Business Processes.143

LECTURE 21

Measuring Operational Performance.150

LECTURE 22

Keeping an Eye on Your Margins.157

LECTURE 23

Leveraging Your Supply Chain.164

LECTURE 24

Reducing Risk, Building Resilience.171

Critical Business Skills: Finance and Accounting

Scope.181

LECTURE 25

Accounting and Finance—Decision-Making Tools.183

LECTURE 26

How to Interpret a Balance Sheet.190

LECTURE 27

Why the Income Statement Matters.198

LECTURE 28

How to Analyze a Cash Flow Statement.206

LECTURE 29

Common Size, Trend, and Ratio Analysis.213

LECTURE 30

Cost-Volume-Profit Analysis.220

xiii

Table of Contents

LECTURE 31

Understanding the Time Value of Money.228

LECTURE 32

The Trade-Off between Risk and Return.236

LECTURE 33

How Investors Use Net Present Value.244

LECTURE 34

Alternatives to Net Present Value.252

LECTURE 35

Weighing the Costs of Debt and Equity.259

LECTURE 36

How to Value a Company’s Stock.267

Critical Business Skills: Organizational Behavior

Scope.279

LECTURE 37

Achieving Results in Your Organization.281

LECTURE 38

The Value of Great Leadership.288

LECTURE 39

Emotional Intelligence in the Workplace.295

LECTURE 40

The Art of Effective Communications.303

LECTURE 41

The Motivation-Performance Connection.310

XIV

Table of Contents

LECTURE 42

Winning with Teamwork.317

LECTURE 43

Coaching—From Gridiron to Boardroom.324

LECTURE 44

Understanding Power Relationships.331

LECTURE 45

Handling Workplace Conflict.338

LECTURE 46

Ethics and the Bathsheba Syndrome.345

LECTURE 47

Leading Real Organizational Change.352

LECTURE 48

Lifelong Learning for Career Success.359

Critical Business Skills: Marketing

Scope.369

LECTURE 49

What Is Marketing?.371

LECTURE 50

How to Segment a Market.377

LECTURE 51

Targeting a Market Segment.384

LECTURE 52

Positioning Your Offering.391

Table of Contents

LECTURE 53

Identifying Sources of Sales Growth.398

LECTURE 54

Deriving Value from Your Customers.405

LECTURE 55

Creating Great Customer Experiences.412

LECTURE 56

The Tactics of Successful Branding.419

LECTURE 57

Customer-Focused Pricing.426

LECTURE 58

Marketing Communications That Work.433

LECTURE 59

The Promise and Perils of Social Media.439

LECTURE 60

Innovative Marketing Research Techniques.446

SUPPLEMENTAL MATERIAL

Bibliography.454

XVI

Disclaimer

The financial information provided in these lectures is for informational
purposes only and not for the purpose of providing specific financial advice.
Financial investing carries an inherent risk that you will lose part or all of
your investment. Investors must independently and thoroughly research and
analyze each and every investment prior to investing. The consequences
of such risk may involve but are not limited to federal/state/municipal
tax liabilities, loss of all or part of the investment capital, loss of interest,
contract liability to third parties, and other risks not specifically listed herein.
Use of these lectures does not create any financial advisor relationship with
The Teaching Company or its lecturers, and neither The Teaching Company
nor the lecturer is responsible for your use of this educational material or
its consequences. You should contact a financial advisor to obtain advice
with respect to any specific financial investing questions. The opinions and
positions provided in these lectures reflect the opinions and positions of the
relevant lecturer and do not necessarily reflect the opinions or positions of
The Teaching Company or its affiliates. Pursuant to IRS Circular 230, any
tax advice provided in these lectures may not be used to avoid tax penalties
or to promote, market, or recommend any matter therein.

The Teaching Company expressly DISCLAIMS LIABILITY for any
DIRECT, INDIRECT, INCIDENTAL, SPECIAL, OR CONSEQUENTIAL
DAMAGES OR LOST PROFITS that result directly or indirectly from the
use of these lectures. In states that do not allow some or all of the above
limitations of liability, liability shall be limited to the greatest extent allowed
by law.

XVII

xviii

Critical Business Skills:
Strategy

Michael A. Roberto, D.B.A.

Critical Business Skills: Strategy

Scope:

S uccessful businesses formulate a clear competitive strategy. They
make the tough choices about how and where to compete. These firms
do not try to be all things to all people. Instead, they select their target
markets carefully, and they choose what not to do. By making clear trade¬
offs, they develop a distinctive position in the marketplace, and they make it
quite difficult for established rivals to engage in successful imitation.

In this section of the course, we will explore the fundamental question: Why
do some firms perform better than others? To answer this question, we will
examine two factors: industry attractiveness and competitive advantage. We
will learn that some industries earn much higher returns on investment than
others. In the first six lectures, we will introduce a framework for analyzing
industry structure and explaining the substantial differences in profitability
across industries. Of course, companies can earn higher returns than their
competitors by building competitive advantage within whichever industry
they choose to compete. We will examine how firms establish a distinctive
competitive position and create competitive advantage over rivals. Moreover,
we will analyze how firms can sustain that competitive advantage against a
variety of external and internal threats. Most firms cannot sustain advantage
for a lengthy period of time. We will try to understand why and how leading
companies lose their competitive edge.

The second six lectures shift focus from business strategy to corporate
strategy. The latter topic emphasizes the strategic choices faced by
diversified, multi-business unit companies. We will examine why these
firms choose to expand their horizontal and vertical scope. In this section,
we ask the fundamental question: Is the whole worth more than the sum of
the parts? In other words, how can companies create (or destroy) value by
choosing to own and operate multiple business units competing in different
product markets? This section of the course closes by examining the role

Scope

of the entrepreneur. We examine how start-ups can use a lean approach to
launching a new business, while applying many of the strategic concepts
introduced in these lectures.

Throughout the lectures, we will use a wide variety of case studies to
introduce key concepts from the field of competitive strategy. For instance,
we will examine the dynamics of such industries as airlines, personal
computers, and pharmaceuticals. We will look at how such firms as
Apple have positioned themselves to succeed in challenging competitive
environments. We will explore how Trader Joe’s made a series of trade¬
offs to establish a position that others could not imitate easily, and we will
analyze the competitive battle between Blockbuster and Netflix. We will also
explore the diversification and vertical integration strategies used by such
firms as Disney and Zara. As we examine these case studies, we will see how
the core ideas of business strategy work in practice, not just in theory. ■

Strategy is Making Choices

Lecture 1

A ndy Grove, the CEO of Intel, has noted that in business, only
the paranoid survive. As proof of this idea, consider what has
happened in just a few industries in recent years: The movie rental
business Blockbuster has been toppled by Netflix; record stores have given
way to music-streaming services, such as Spotify; and taxicabs may soon
be supplanted by Uber. In each of these industries, a disruptive rival has
emerged and threatened or eliminated the incumbent players. In this section
of the course, we will try to understand how you can sustain a competitive
advantage in your industry or how, as a new entrant, you can plot a strategy
to knock off the top players.

The Field of Business Strategy

• The field of business strategy might be said to have emerged from
an ancient Chinese military treatise, The Art of War , written by Sun
Tzu. Many in business have used this text to formulate ideas on
how companies can build and sustain competitive advantage.

• In the 1950s and 1960s, leading business schools began to explore
the idea of competitive strategy. In the early 1960s, the business
historian Alfred Chandler studied some of America’s great 20 th -
century corporations. He noted that as those firms changed their
strategies, they also had to change their organizational structures,
systems, and processes. For this reason, he argued that strategy
drives structure in large organizations.

• But in 1970, Joseph Bower at Harvard Business School turned that
argument on its head. He didn’t disagree with Chandler, but he
argued that in some companies, structure can also drive strategy. The
choices a firm makes regarding systems, organizational structures,
processes, measurements, and so on can drive the firm’s future.
Such choices are behind the kinds of ideas that bubble up from
below about new products and services and reach top management.

Lecture 1: Strategy Is Making Choices

• The modem field of strategy was initiated by Ken Andrews and
his colleagues at Harvard Business School. They argued that
strategy is a pattern of choices that reveals the purpose and goals
of an organization.

• Economics has also influenced the field of strategy. Michael Porter
was one of the early economists who began to fuse ideas from
economics with ideas from the field of business management.

Organizational Performance

• The fundamental question we’ll try to answer in these lectures on
strategy is simple: Why do some firms perform better than others?
To answer this question, we must look at two factors: industry
attractiveness and competitive advantage.

• Industry attractiveness simply means that some industries are
more profitable than others. In those environments, there are more
opportunities for more companies to make healthy returns. In other
industries, it’s much more difficult for firms to make money. Thus,
one part of explaining a firm’s performance is understanding the
environment in which it competes.

• But we also then have to understand how a firm competes against its
rivals. Does it have an advantage over rivals? Is it able to generate
returns above the industry average? And can it do so year after
year? That’s what we mean by competitive advantage.

• We can also identify two key questions related to competitive
advantage: (1) How do you establish a distinctive competitive
position and create advantage over your rivals? (2) How do
you sustain that advantage against a variety of external and
internal threats?

o We live in a world where information is readily available and
moves quickly. Anyone can get on the Internet and learn about
competitors. Consultants can be hired to help benchmark a firm
against the competition.

o Without question, if you’ve proven that you have a successful
product or service, if your customers are happy and your
investors are getting attractive returns, others will try to imitate
you. They will look for a slightly better way to do what you’re
doing—and they won’t stop.

o For this reason, understanding how to sustain competitive
advantage is crucial to business strategy.

Strategic Planning

• Porter has argued for the importance of having an explicit process
for formulating strategies, for understanding the goals of a
corporation and how they will be achieved. But some have been
much more skeptical and critical of the idea of strategic planning in
organizations. For example, management professor Russell Ackoff
said, “Most corporate planning is like a ritual rain dance. It has no
effect on the weather that follows, but it makes those who engage in
it feel that they are in control.”

In many corporate strategic planning processes, discussions focus more on
financial targets and budgets than about where and how to compete.

Lecture 1: Strategy Is Making Choices

• It’s important to note that Ackoff is criticizing the strategic planning
process as it occurs in many companies. That process, especially
in large organizations, tends to be bureaucratic and cumbersome. It
takes a great deal of time, and it tends to focus on budgeting rather
than strategy. In contrast, strategy formulation should focus on
where and how to compete.

• Some have also criticized the field the strategy by arguing that it’s
simply not appropriate to talk about establishing and sustaining
competitive advantage in today’s turbulent environment.

o Rita McGrath at Columbia has said that competitive advantage
is transient. It’s simply too difficult, she says, for firms to
establish an advantage and sustain it over a long period of time.

o According to McGrath, firms must adapt constantly, managing
a pipeline of initiatives, not just one strategy. Any organization
should experiment, iterate, and learn. Adapting is what great
firms do, not plotting a distinctive position and trying to
sustain it.

• Roger Martin from the University of Toronto disagrees with
McGrath. Strategy, he says, should not be confused with strategic
planning processes. Yes, your organization should adapt and iterate,
but you must begin with a clear set of choices. You must know the
direction in which you’re headed. From there, you can adapt. But
many managers, according to Martin, embrace the adaptive view
because they don’t want to make hard choices.

• Both Martin and McGrath fundamentally agree that strategy
ultimately comes down to making choices about what to do and what
not to do. And Martin would agree with McGrath that competitive
advantage is more fleeting today than it was decades ago. But Martin
believes an organization must start with a clear direction; from there,
managers must scan the market, the customer, and the competition
and be ready to flex the strategy appropriately.

• It’s generally not the case that strategy formulation is explicit,
conscious, and purposeful. It’s more often the true that strategy
emerges and evolves over time. It’s important to think about
strategy as a pattern in a stream of decisions and actions; it’s not an
event but a process.

• The authors of Playing to Win have noted five key questions to ask
yourself when plotting strategy:

o What’s your winning aspiration? In other words, what are you
trying to achieve?

o Where will you play—in what product markets, segments,
and geographies?

o How are you going to win? That is, what are you going to do
that will give you an advantage over the competition?

o What capabilities must be in place to execute your strategy?

o What management systems are required to implement your
strategy?

Competition

• Four facts about competition will set the stage for our analysis
of competitive environments as we move through these lectures.
First, industries vary widely in their profitability. That is, in some
businesses, it will be difficult to make money no matter how smart
the management team or how great the strategy.

• Second, the industry you’re in matters a great deal; in other words,
sometimes there are forces beyond your control driving your
profitability. Those in the newspaper business, for example, have
learned this lesson as the Internet has grown.

• Third, competitive advantage may be fleeting.

Lecture 1: Strategy Is Making Choices

• Fourth, industry structure varies widely around the world. It’s
true that we live in a more global world today, but competitive
environments can look very different in different parts of the
world for a variety of reasons, from consumer tastes and culture to
government regulation and institutions.

Industry Structure and Competitive Advantage

• In 2013, the return on assets for Pfizer, a pharmaceutical company,
was 12.8%. For Alaska Airlines, it was 8.7%. Can we conclude that
Pfizer is a better-managed firm than Alaska Airlines? No, we can’t
look only at absolute financial returns to make conclusions about
these two companies.

o The pharmaceuticals industry is high profit, while the airlines
industry is low profit. If we look more deeply, we would learn
that Alaska Airlines outperforms rivals in its industry.

o That’s the key comparison we need to make. We’re looking for
companies that generate excess returns relative to the industry
average; that’s competitive advantage.

• As we look across industries, we also see that in some industries,
the leader in one year is much more likely to stay on top than the
leader in other industries. In other words, competitive advantage is
fleeting, but it’s more fleeting in some industries than others.

• The fact that you’re in an industry that’s low profit doesn’t mean
you can’t make money.

o In the supermarket business, many firms generate returns on
assets in the low single digits, but if we look at the major
competitors, we still see variation in returns. For example,
in 2012, Whole Foods generated an 8% return on assets,
while Kroger generated 2.6%. Even though the industry as
a whole generates thin margins, we see wide variation across
major competitors.

o This tells us that Whole Foods has found a way to build a
strong competitive advantage in an otherwise structurally
unattractive business. In the coming lectures, we’ll look at a
number of companies that have done just that. As we’ll see, we
can learn more about strategy by studying companies in tough
businesses to identify how they achieved a distinctive position
than we can by looking at companies that compete with many
other players that also generate healthy earnings.

Suggested Reading

Arbesman, “Fortune 500 Turnover and Its Meaning.”
Lafley and Martin, Playing to Win.

McGrath, The End of Competitive Advantage.

Questions to Consider

1. Should firms establish a long-term strategy, or should they embrace a
more adaptive approach to management?

2 . Why do many strategic planning processes fail to produce positive
results?

3. Why is it so difficult for firms to sustain high performance?

Lecture 2: How Apple Raises Competitive Barriers

How Apple Raises Competitive Barriers

Lecture 2

R ichard Branson, the British entrepreneur and successful founder
of the Virgin Group, once joked that it’s rather easy to become
a millionaire; you simply start as a billionaire, then go into the
airline business. Warren Buffett, in his analysis, found that the airline
industry as a whole has lost money for the last 100 years. What explains
the difference between the notoriously low-profit airline industry and high-
profit industries, such as pharmaceuticals? In this lecture, we’ll look at
Michael Porter’s seminal work on the five forces that shape strategy, which
offers a comprehensive framework to help understand these differences in
profitability across industries.

The Five Forces

• The first of Michael Porter’s five forces shaping strategy is barriers
to entry. As Porter argued, high barriers to entry improve the
profitability of an industry.

• The second force is the threat of substitutes, that is, alternative
products or services that fulfill the same need. These may not
always be direct rivals but, in some cases, quite different products
or services than the ones you’re selling. For example, substitutes for
fitness centers might include home workout equipment, diet plans,
video game systems for exercising, and even local bars, because
some people join fitness centers for social purposes.

• The third force shaping strategy is the bargaining power of suppliers.

Who provides the key inputs and components for your product or
your firm, and do those suppliers have leverage over you? Can they
extract some of the profits you might otherwise make?

• The fourth force shaping strategy is the bargaining power of
the customer. Again, who has the leverage in the buyer-seller
relationship?

• Finally, the fifth force is rivalry among existing competitors. In
particular, it’s important to consider whether firms in the industry
compete hard on price. Are there frequent price wars in the industry,
or is the environment one of friendly competition, perhaps one in
which competitors engage in mutually beneficial activities?

Applying the Framework: Airlines

• At first glance, barriers to entry might seem high in the airline
industry, yet over the past few decades, the industry has seen many
new players. In fact, the barriers aren’t as high as they initially
appear. A new entrant can lease old planes rather than buying new
ones. In addition, entrants don’t have to fight for slots at large,
expensive airports but can easily gain access to regional airports,
where states and counties are trying to draw traffic for economic
development and tourism.

• However, buyer power in the airline industry is high. Customers
don’t see much differentiation in airlines and aren’t particularly
loyal. Moreover, air travel customers are highly price sensitive, and
they can look for bargains on travel websites, which offer perfect
price transparency.

• Supplier power is also high. Airbus and Boeing provide jumbo jets
and a few other players provide regional jets, but there aren’t many
alternatives when it comes to buying planes. As for labor, airlines
have to negotiate with powerful unions. And the price of fuel is
driven by OPEC.

• These days, there are also numerous substitutes for air travel,
including other forms of transportation, such as cars or trains,
and technology, such as video conferencing, which allows
businesspeople to avoid traveling to meetings.

• Finally, the airline business has a unique characteristic that drives
intense price competition: The business has very high fixed costs
and virtually no variable or marginal costs.

Lecture 2: How Apple Raises Competitive Barriers

o Getting the plane in the sky involves all fixed costs; there
is very little expense that varies depending on how many
passengers are on the plane.

o In that situation, anything an airline receives above zero is
what’s called contribution margin —dollars that could go
toward covering fixed costs or toward profitability. Thus, there
is intense price competition to try to fill seats.

As you can see, the five
forces framework is
useful for examining the
competitive environment
in a systematic fashion.

If, for example, consumer
tastes or technology are
changing in a substantial
way, the framework
can be used to help

understand the potential
impact of those changes
on profitability,
o You can also use

the framework to

think about how you

might position your
company to deal

with threats. In a tough industry, can you find a segment that
is, perhaps, a little more profitable, allowing your business to
thrive when others are losing money?

With the drive to reduce obesity, fitness
centers have been seen as an attractive
business, but in fact, overall, this
industry hasn’t generated much profit.

o Finally, you might be able to think about how your firm, as a
leading company in the industry, might shape a more favorable
industry structure. Can you, perhaps, raise barriers to entry,
thereby increasing your own profitability and making the
environment better for all?

The Spectrum of Competition

• Economists, such as Porter, typically examine the behavior of
firms in the economy by building models of perfect competition.
These models usually encompass the following assumptions: There
is free entry and exit into the business; there are many buyers and
sellers, all of which are relatively small and equal in size; complete
information is available about the goods and services; the goods
are homogeneous; and each firm is trying to maximize profits.
Economists argue that the result of perfect competition is maximum
social welfare.

o Economic profits in this world of perfect competition equal zero,
although that’s not to say that firms make no accounting profits.

o Accounting profits do not include opportunity costs for
the labor and the capital that are deployed in a firm, while
economic profits account for opportunity costs.

• In the past, economists who studied industrial organization tended
to examine markets characterized by imperfect competition from
the perspective of the consumer. They were looking for antitrust
issues. Were there instances of imperfect competition where firms
might be engaging in behavior that harms consumers or diminishes
social welfare?

• Porter, however, looked at markets from the perspective of a
company and found that businesses want imperfect competition.
They don’t want economic profits to be zero, but they also don’t
want to create antitrust concerns. Thus, he reversed the assumptions
of perfect competition.

• According to Porter, CEOs should look for businesses where
there are barriers to entry and exit. Further, the goods should not
be homogeneous but differentiated. Those who can find these
imperfections in an industry—or help shape them—can drive
economic profits higher. And that’s what you’re looking for as you
shape strategy.

Lecture 2: How Apple Raises Competitive Barriers

• Of course, what we’re thinking about here is really a spectrum
of competition. On one end, we have many buyers and sellers,
homogeneous goods, and no barriers to entry. On the other end,
we have one firm with 100% market share. In between, we might
have a number of situations, including fragmented markets with
buyers and sellers of different sizes; an oligopoly, with three or four
dominant players in an industry; and so on.

Steps in a Five Forces Analysis

• The first step in a five forces analysis is to define the industry you
wish to analyze.

• The next step is to identify the players, including the buyers,
suppliers, and rivals. When you’re looking at buyers, remember to
think about all the buyers, not just the end user but the distributor,
retailer, and others along the supply chain.

• Next, you should assess the strength of each force using quantitative
evidence. Look at the profitability of other companies in the business.

• Finally, you can’t look to the past only; you must look forward,
trying to understand the critical trends within the business. How can
you project, based on your assessment of the environment, where
each of the forces will be in the years ahead?

Crafting Strategy with the Five Forces

• One of the applications for the five forces framework is to craft a
strategy that mitigates the negative forces in an industry. Consider,
for example, Apple, which is in an industry with low barriers
to entry, high buyer and supplier power, intense rivalry, and
multiple substitutes.

• One way Apple mitigated these negative forces was to construct its
own operating system. This step made it difficult for others to enter
Apple’s market and become direct competitors.

• Further, the Apple operating system fundamentally differentiates
the company’s products, making the products easier to use. And
the operating system mitigates the power of Microsoft; Apple is not
dependent on buying Windows, as other PC makers are.

• Apple also established its own stores, which mitigates the power of
the big-box retail chains and online retailers.

• As for substitutes, Apple has been willing to cannibalize itself—
to build tablets and smartphones. The company has gotten into the
substitute business for its own products, rather than letting others
do so.

Common Mistakes with the Framework

• One common mistake in five forces analysis is to apply the
framework to a company, rather than an industry. In addition,
management teams may not define the industry clearly when they
begin to do their analysis.

• It’s also common for managers to spend too much time looking
back, rather than trying to understand the trends that might affect
the future. Some managers might also ignore the full range
of substitutes.

• Note, too, that you can’t give equal weight to all five forces,
thinking that if four of the five are in your favor, your business is in
good shape. Even one negative force can cause harm.

• As we said, you can’t presume that industry structure is the same
around the world. For example, in Australia, several firms dominate
the wine business, while in France, there are more than 200,000
independent wineries. It would be difficult to do a single five forces
analysis for the global wine industry.

Lecture 2: How Apple Raises Competitive Barriers

• Finally, it’s important to take into account the limitations of the
framework: It works primarily for industries where there are
clear boundaries, it provides limited tools and techniques for
understanding the nature of rivalry, and it doesn’t address the
issue of complements—a product or service that adds value to the
original product offering when the two are used together,
o Gillette pioneered the business model of complements. The
company sells razors at a low cost because it knows that if
customers like the razor, they’ll buy blades forever.

o Apple turned this traditional razors-and-blades strategy around
when it entered the iPod, iPhone, and iPad market.

o Before the iPhone, people paid very little for phones. How,
then, has Apple induced customers to pay $400 or more for
phones? Ask yourself: How do you get people to buy expensive
peanut butter? By giving them lots of cheap jelly. And that’s
what Apple has done with its free and low-cost apps.

Suggested Reading

Brandenburger and Nalebuff, Co-opetition
Porter, Competitive Strategy.

Questions to Consider

1. Why do some industries generate much higher profits than others?

2. What types of strategies can firms use to mitigate negative aspects of
industry structure?

3. What are some examples of firms for which complements are a crucial
element of strategy?

The Danger of Straddling

Lecture 3

W hat’s different about the competitive strategies of Dell, Mercedes,
and JCPenney? Dell tries to be the low-cost player in the personal
computer market, while Mercedes tries to be a differentiated
player in the automobile market. JCPenney seems to be stuck in the middle—
achieving neither a low-cost strategy nor a differentiation strategy. As we’ve
discussed, strategy involves understanding your competitive environment,
then positioning yourself for success in that environment. In the last lecture,
we saw how to understand the environment by conducting a five forces
analysis. In this lecture, we’ll try to understand the resources and capabilities
that will enable you to succeed in that environment.

Creating Economic Value

• Professor Robert Grant wrote that strategy is concerned with
matching a firm’s resources and capabilities to the opportunities
that arise in the external environment. As you do this—as you plot
your strategy and try to position yourself—you’re trying to create a
competitive advantage relative to your rivals. To do that, you must
create more economic value than your rivals.

• What does it mean to create economic value? When you produce
and sell a good or service, customers have a certain perceived value
for that good and service. There is also a cost, of course, for you to
deliver that product or service to customers. The perceived value
less the total cost equals the economic value created.

• Of course, the company that provides a good doesn’t get all of the
economic value created. That value is split between the company
and the consumer.

o Anything consumers pay that’s less than what they’re willing
to pay—less than what they perceive as the value for that
good—is surplus to them. That’s part of the economic value
that they get.

Lecture 3: The Danger of Straddling

o Any price or revenue that the company can achieve that’s
higher than the cost of producing and delivering the good is
surplus, or profit. And the goal of a firm is to generate more
economic value than the competition. That’s what we mean by
achieving competitive advantage.

Fundamental Strategy Choices

• There are three basic types of competitive advantage that firms can
strive to achieve: low cost, differentiated, or dual.

• In addition, competitive scope can be categorized into two
basic types:

o A firm might be a niche competitor, competing with a fairly
narrow product line and focusing on a particular geography
and a small target market.

o A firm might also choose to be a broad competitor, offering a
wide array of products, competing in an expansive geographical
setting, and serving a wider target market.

• These are the fundamental choices that firms must make as they
choose strategy: What type of advantage does the firm seek, and
how focused or broad will it be in terms of product, geography,
and customer?

Competitive Advantage

• In thinking about competitive advantage, we start with the average
competitor in an industry and the amount of economic value it creates.
What is the gap between the willingness to pay for this competitor’s
product and the cost to deliver that product to customers? In trying
to achieve competitive advantage, you want to generate a larger gap
between willingness to pay and cost than your competition.

• For example, Mercedes tries to generate much higher willingness
to pay than Chevrolet. Of course, costs for Mercedes are higher
than they are for the firm’s competition. If Mercedes wants to
be a successful differentiated player, it will seek a much higher

willingness to pay but only slightly higher costs, so that the
gap between willingness to pay and cost is higher than it is for
the competition.

• A successful low-cost player tries to drive its costs much lower than
those of its rivals. In the process, the low-cost player sacrifices a bit
of willingness to pay.

• A third way to achieve competitive advantage is the dual strategy,
with both a higher perceived value and a lower cost structure
than the competition. This dual advantage is extremely difficult
to achieve.

o A firm that’s trying to achieve higher willingness to pay and
create more perceived value will have higher costs. It will to
have to invest in research and development, branding, and high-
quality components. It’s difficult to have much lower costs than
the competition if you’re trying to create a premium product.

o Likewise, if you’re trying to bring your costs down
significantly, it may be difficult to command the same brand
image and position in the market and be able to achieve the
same pricing.

o With a dual strategy,
players that are focused
on either differentiation
or low cost may be able to
attack you. If you’re trying
to sell a vehicle at a high
price, yet you’re trying to
achieve lower costs than the
competition, Mercedes may
critique the quality of your
vehicles. Similarly, another
player may have a strong
cost position and be able to
undercut you on price.

A high-end clothing store might
generate high gross margins,
have higher expenses, and
accept lower inventory turnover
than a more mainstream retailer.

Lecture 3: The Danger of Straddling

• Interestingly, a firm’s financials often tell us what type of
competitive advantage it’s trying to achieve. For example, consider
the financials of Walmart relative to Target.

o Walmart has much lower gross margins than Target; lower
overhead costs; and lower selling, general, and administrative
expenses, but it has much higher asset turnover than Target.

o Target’s high gross margins and lower turns paint a picture of
a typical differentiation strategy. Target has higher margins
because it has chosen to sell slightly higher-quality goods—
more fashionable items—and sets higher prices in some
categories. Target has lower inventory turns because it sells
fewer of the basics than Walmart.

Competitive Strategies

• Thus far, we can see that there are four generic competitive
strategies:

o Broad differentiated, used by Starbucks, for example. Here,
we see a firm with a wide target market, competing in many
geographies with a premium-priced (differentiated) product.

o Focused differentiated, used by the motorcycle manufacturer
Ducati. This Italian firm serves a narrow target market with a
limited selection of products.

o Broad low cost, used by Walmart, which serves a wide range
of customers in many geographies with many products
and services.

o Focused low cost, used by the Irish airline Ryanair. This carrier
serves certain geographies with a well-defined product set and
a much narrower target market than major airlines.

• None of these strategies is “the best”; the mistake firms make
in choosing strategies is to be unclear about where the firm is
situated—to be stuck in the middle. This situation can occur when

firms fail to choose a strategy, try to shift strategy blit don’t make
the shift successfully, or react inappropriately to the emergence of a
new competitor.

Competitive Advantage as a System

• We need to think of competitive advantage as an integrated, self¬
reinforcing system of capabilities, resources, and choices. With this
mindset, crafting an effective strategy means that your firm must
be different; you can’t simply copy the assortment of resources and
capabilities that your rivals have achieved.

• The idea behind thinking of competitive advantage as a system is
that one choice you make enhances the value of other choices, and
one capability you develop creates stronger capabilities elsewhere.
If these capabilities and choices fit together well, not only can you
create a powerful advantage, but it can also be difficult for others to
copy your system.

• Consider, for example, some of the early choices made by Walmart:
an everyday low-price strategy, little national advertising, a focus on
rural locations, a network of stores built around distribution centers,
frugal travel policies, and no regional offices. Each of these choices
reinforced other choices. For example, having an everyday low-
price strategy fits well with not doing much national advertising.

• Competitors often look at what they think a firm does best and try
to emulate that one part of the system. For example, a competitor
might try to emulate Walmart’s supply chain or logistics, but there
are two mistakes inherent in this approach.

o First, it isn’t one thing that Walmart does that’s a silver bullet.
It’s how Walmart’s logistics plan and system fit with everything
else it does that creates advantage.

o Second, any potential competitor has its own system of
activities that’s quite different than Walmart’s. Choosing one
element of Walmart’s system and trying to drop it into another
system won’t achieve the same advantage.

Lecture 3: The Danger of Straddling

• Even a firm with a well-integrated, successful system may face
difficulties if it tries to move into a new segment. This has been
the case with Walmart’s attempt to move into the wholesale club
business with Sam’s Club. Although Sam’s Club is profitable, it
is outperformed by Costco because Sam’s Club is too tied to the
legacy of Walmart to truly serve the different set of customers who
shop at wholesale clubs.

• Another problem firms face when they have successfully tailored
their activities to a particular environment is rigidity. They
become committed to past choices and unable to adapt if the
environment changes.

o Because core capabilities can become rigid, successful entrants
to an industry are often able to use the incumbent’s strengths
against it. Dell used this judo strategy when it took on IBM.

o IBM had tremendous manufacturing capability to produce high
volumes of its standardized products at low cost. It also had
well-developed relationships with its distribution channel—
retailers, wholesalers, and value-added resellers.

o Dell built its strategy in such a way that these strengths of
IBM became liabilities. IBM couldn’t go direct and sell online
because if it did, it would alienate many of its wholesalers and
retailers. Further, IBM’s factories weren’t configured to build
customized products.

Threats to Competitive Advantage

• The ability to be successful as a firm, to be more profitable than
your rivals, is about not just achieving advantage but sustaining it.
And to sustain advantage, you have to address three major external
threats: imitation, substitution, and holdup (gaining leverage) by
buyers and suppliers.

• Internally, firms face the threat of not perceiving and reacting
adequately to threats. Incumbent players sometimes don’t see a
threat early enough, don’t know how to respond, or can’t motivate
their organizations to respond quickly enough when threats emerge.

• One final threat is the risk of engaging in herd behavior. In many
markets, companies aren’t trying to be as different as they could be.
This stems from risk aversion on the part of executives. If strategy
is about identifying different activities and different positions in the
marketplace, herd behavior is the antithesis of great strategy.

Suggested Reading

Ghemawat and Rivkin, “Creating Competitive Advantage.”
Montgomery, The Strategist.

Porter, Competitive Advantage.

Yoffie and Kwak, Judo Strategy.

Questions to Consider

1. How and why do firms end up “stuck in the middle” in terms of
competitive positioning?

2. Why is it so difficult for rivals to copy such a firm as IKEA?

3. Why do successful firms sometimes struggle when they move into
adjacent markets?

Lecture 4: What Trader Joe’s Doesn’t Do

What Trader Joe’s Doesn’t Do

Lecture 4

S uppose that several decades ago, a Stanford M.B.A. named Joe
Coulombe asked you to invest in his new grocery retailer. He planned
to open small stores in low-rent strip malls, offer a limited selection
of goods, and do very little advertising. You probably would have made the
mistake of turning down that investment, as many others did. But Coulombe
went on to open a chain called Trader Joe’s that became one of the most
successful grocery retailers in the last few decades. In this lecture, we’ll
explore how Coulombe created a business where people want to work,
customers want to shop, and investors want to put their money.

The Importance of Trade-Offs

• Unlike most other grocery stores, Trader Joe’s doesn’t offer many
branded products; almost all of its products are private label. Its
stores don’t have large parking lots or wide aisles. It doesn’t offer
self-checkout, accept coupons, or have a loyalty card. It doesn’t
really run sales, doesn’t advertise on television, and doesn’t have
a large selection of items. Finally, there is no stable product line at
Trader Joe’s.

• As Michael Porter once wrote, “The essence of strategy is choosing
what not to do.” You can’t be all things to all people, which means
that you have to choose not just what you will do but what you
won’t do. You need to have a clear understanding of the things
your rivals offer that you choose not to offer. Such trade-offs make
your firm distinct from your competitors, make it hard for existing
players to imitate you, and can help you mitigate the negative forces
in your industry.

• Some of the leading firms in past decades have achieved success by
making firm choices about what they would not do and emphasizing
those trade-offs.

o Southwest Airlines, for example, doesn’t offer assigned seats,
uses smaller regional airports, has only one kind of plane in its
fleet, doesn’t allow customers to transfer bags to other airlines,
and doesn’t operate a hub-and-spoke system. Southwest has
chosen not to do what many major airlines have done.

o Likewise, Planet Fitness has positioned itself as a gym for
people who aren’t fitness nuts, and it emphasizes this trade¬
off approach in its advertising. By doing so, the firm hopes
to attract customers who are more casual about their fitness
regimes, those who want to lose a few pounds but don’t want
to be intimidated by bodybuilders.

Preventing Imitation

• Because of the trade-offs it has made, Trader Joe’s has made it
difficult for other grocery retailers to become imitators. Consider
Kroger, for example, a large supermarket chain. Kroger has made
historical commitments that are rigid. It already has large stores
with wide aisles, and it can’t change that format to mimic Trader
Joe’s. Kroger also has many branded goods and offers sales each
week. It couldn’t easily shift to everyday low pricing. To some
extent, Kroger is stuck with the choices it has made.

• Moreover, the mindset of people operating a typical grocery store is
quite different than the mindset of Trader Joe’s leadership, and it’s
difficult to change mindset, as well. Tesco, a British retailer, tried to
set up a separate subsidiary to build a chain of smaller-format stores
to compete directly with Trader Joe’s. But Tesco ended up stuck in
the middle—creating something that was neither as good as Trader
Joe’s nor as effective as its main business.

Mitigating Negative Forces

• Trader Joe’s strategy of making trade-offs has also helped the store
mitigate negative forces in terms of industry structure.

Lecture 4: What Trader Joe’s Doesn’t Do

• The unique array of private-label products that are unavailable at
other retailers diminishes both buyer power and competitive rivalry.
When you’re not selling the same goods that other stores sell, people
can’t compare prices, and you don’t get dragged into price wars.

• The distinctive in-store experience at Trader Joe’s mitigates both
buyer power and rivalry, and it helps to counter the threat of
substitutions from other retail formats, including e-commerce. The
everyday low pricing strategy also minimizes price rivalry and
buyer power.

• In addition. Trader Joe’s willingness to alter its product mix
frequently mitigates supplier power. The store maintains a credible
threat with regard to discontinuing products. Because customers
don’t know who makes the private-label items for Trader Joe’s, the
firm can also readily change its suppliers to get a better price.

• Finally, locating stores in older strip malls offsets the power of real
estate firms and landlords that charge high rents to many retailers.

The Growth Trap

• The growth trap is a primary reason that other firms don’t make
trade-offs. CEOs want to grow revenue, and they believe that trade¬
offs could constrain growth. Obviously, as you make trade-offs,
you narrow your target market, which makes it difficult to grow
sales aggressively.

• Publicly traded firms definitely feel pressure to meet Wall Street
expectations. But it’s also true that large firms get more publicity,
and their executives often receive higher compensation. Thus, there
are some personal interests driving the obsession with growth for
many companies.

• There’s also a real challenge when CEOs set aggressive growth
targets. What does it mean if a CEO sets a target of 15% or 20%
growth per year?

o Mathematicians have a rule of 72 that helps us think about the
growth of any number. If we divide 72 by the growth rate that a
firm aspires to achieve, we get the number of years it will take
for that firm to reach its target.

o If a firm is trying to grow at 20% per year, it will take about
3.5 years for that firm to reach its target. How is a firm that
might have been around for 40 or 50 years going to achieve
20% growth in such a short period of time? In many cases, it
does so by violating key trade-offs it originally made.

o A firm might have started with a long list of things it didn’t
plan to do—things that made it distinct but create a narrow
target market. To go beyond that market, the firm begins to
eliminate a few of the trade-offs.

A Dual Advantage Strategy?

• Some observers have pointed to Trader Joe’s as an example of a firm
pursuing a dual advantage strategy, achieving both differentiation
and low costs. However, the reference point here is crucial.

• If we compare Trader Joe’s to a typical supermarket, it might seem
to have slightly higher prices and lower costs. But in comparison to
other organic or natural stores, such as Whole Foods, Trader Joe’s
prices are clearly lower; therefore, it’s hard to argue that the store is
a differentiated player.

• The bottom line is that it’s difficult to come to a definitive
conclusion about the issue of dual advantage with Trader Joe’s
because it’s not a publicly traded company. We don’t have financial
data on the company, and because it offers private-label goods,
it’s difficult to even assess the price level at the firm. We can’t tell
if Trader Joe’s prices are lower than those of a given competitor
because the products are not identical in both locations.

Lecture 4: What Trader Joe’s Doesn’t Do

• This issue of dual advantage highlights the fact that many people
confuse the term differentiation with the general notion of being
different than the competition. Low-cost players can be highly
distinctive, but that doesn’t mean they’re differentiated in the
precise way that Porter initially defined the term. In the original
generic strategies framework, differentiation meant creating a larger
wedge between willingness to pay and costs than the average rival.

Blue Ocean Strategy

• The concept of blue ocean strategy was introduced in a book of
the same name written by W. Chan Kim and Renee Mauborgne.
These authors argued that dual advantage is not only possible, but
it’s much more prevalent than Porter believed. Kim and Mauborgne
claimed that true innovators are able to break the trade-off between
low cost and differentiation and create a new value proposition that
allows them to deliver both.

• As an example, the authors point to Cirque du Soleil, which is a
hybrid of a circus and a Broadway show. The show charges a
premium price, yet the authors argue that it has lower costs than a
typical circus.

• Southwest Airlines is offered as another example of a blue ocean
company, but it doesn’t charge premium prices. Southwest is a low-
cost player that’s different but not differentiated in the sense that it
enjoys higher willingness to pay than many of its rivals.

• According to Kim and Mauborgne, a blue ocean firm is created by
turning around the strengths and weaknesses of a typical firm in
an industry. Can a new firm be great at things that typical firms in
the industry aren’t doing well? And can a new firm sacrifice or cut
down on things in which other firms invest?

• Cirque du Soleil, for example, invests in choreography and the
composition of beautiful music—things that a typical circus doesn’t
have—but it doesn’t have animals or star performers. By making

those kinds of choices, a new firm can flip the industry on its
head and create a different company, one that doesn’t have direct
competitors.

• Kim and Mauborgne offer what they call the four actions
framework to help people think about how they might redefine
an industry and come up with a strategy that sets them apart from
many competitors. The key questions to ask here are: (1) What can
you eliminate that others are doing? (2) What can you reduce? (3)
What can you create? (4) What can you enhance?

• Interestingly, this model actually seems to have much in common
with Porter’s work, particularly with regard to the idea of trade¬
offs. By eschewing certain activities that are commonplace in an
industry, firms can create a distinctive position that’s hard to imitate.

Homogenization

• In benchmarking, a firm typically looks for things that it’s doing less
effectively than the competition and tries to catch up. Unfortunately,
benchmarking can lead to the homogenization of strategies. This is
not to say that you shouldn’t study the competition, but you may want
to amplify what you do differently rather than just trying to catch up.

Today, we often see many different brands, flavors, and sizes of certain products,
but in the end, the products are just commodities; they’re not truly differentiated.

Lecture 4: What Trader Joe’s Doesn’t Do

• Youngme Moon, a marketing professor at Harvard Business School,
has noted the phenomenon of convergence in many industries, with
rivals becoming increasingly alike. In retail stores, Moon sees what
she calls heterogeneous homogenizing, in other words, there is
diversity on the surface but homogeneity underneath. Companies
are spending a great deal of money to create many varieties of the
same basic products.

• As we’ve seen, however, strategy rests on unique activities. And to
create a sustainable strategic position, you must make trade-offs.
Without making those trade-offs, your ideas can be imitated, and
you won’t be able to sustain your advantage.

Suggested Reading

Ager and Roberto, “Trader Joe’s.”

Kim and Mauborgne, Blue Ocean Strategy.
Moon, Different.

Porter, “What Is Strategy?”

Questions to Consider

1. What is the value of making a series of trade-offs as you formulate a
competitive strategy?

2 . Why do firms have such a hard time imitating a company that has made
a number of trade-offs?

3. Why is it so difficult to achieve dual advantage?

First Movers versus Fast Followers

Lecture 5

F irst-mover advantage is the competitive advantage established
by virtue of the fact that a company has entered a market first and
established a position. And it’s true that first movers sometimes do
achieve tremendous advantage; consider Gillette in razors or Coca-Cola in
carbonated soft drinks. But we also have plenty of examples of first movers
that did not succeed or were completely eliminated from the market. Before
Facebook, for example, there was a social media company called Friendster,
and before Google, there was Netscape. In this lecture, we’ll challenge the
commonly held view that being first is crucial.

Sources of First-Mover Advantage

• First movers gain advantage from four major sources: economies
of scale, economies of scope, network effects, and learning effects.

• Economies of scale exist in a business when the costs per unit to
produce and distribute a good fall as the business produces more
units of the good in any given time period. In other words, the
larger you are, the more your costs per unit come down. Scale
economies are pronounced in such businesses as Toyota, Bank of
America, and FedEx. The higher the volume for any business with
high fixed costs, the greater the degree to which those fixed costs
can be amortized over many units, bringing the cost per unit down.

• Learning effects also bring about falling costs per unit. In this case,
however, the lower costs are not the result of more units being
produced in a given time; instead, they’re attributed to efficiencies
learned from producing the good over an extended period.

• Another source of first-mover advantage is network effect, which
has less to do with cost and more to do with perceived value on
the part of the user. A network effect is seen when the value per
user rises as the total number of users rises. Network effects are

Lecture 5: First Movers versus Fast Followers

in play in such businesses as eBay, Linkedln, Google, eHarmony,
and Amazon. For example, eBay, has value for users because many
other buyers and sellers can be found on the site,
o Presumably, the first mover can gather many users and, thus,
increase its own value to each user. That creates an advantage
over the upstart who comes in with no users and has very little
value to offer.

o Many Internet firms that are in businesses where network effects
exist have pursued the so-called get-big-fast strategy. The first
order of business here is to build a network effect as a defense
against others who might come in later and try to compete;
it’s only after they’ve built the network that these firms figure
out how to make money. In fact, this has been a powerful
phenomenon for such firms as Facebook and Linkedln.

o In markets with network effects, typically, there are high
switching costs for users, which results in a lock-in effect.
Users are, in effect, stuck with a particular good, service, or
platform. From the perspective of the user, that may not be
ideal. But from the perspective of a company offering a product
or service, switching costs are wonderful.

o In some markets with strong network effects, not only is there
a first-mover advantage, but the first mover can also come to be
the dominant technology or firm—the so-called standard in the
market. This is true of Microsoft Windows, which has 90% of
the market share in the operating system market. Keep in mind,
though, that with certain products or services, there may also
be high demand for variety on the part of the customer. This
is the case, for example, with video games, which have a wide
array of customers.

Countering Conventional Wisdom

• The speed at which a given market or technology evolves can have
a significant bearing on whether a dominant player will emerge
with enduring first-mover advantage.

o One product for which there is fairly slow evolution of both
technology and the market is Scotch tape. 3M created this
product in a very slow-moving space and has been able to
achieve enduring first-mover advantage.

o But in the personal computer business, where we’ve seen rapid
technological obsolescence and a great deal of dynamic change
over time, it’s much more difficult to establish and maintain a
first-mover advantage.

• Another reason that first movers don’t always win is that there
may be high costs involved in blazing a new technological trail.
Such costs are known as pioneering costs. In particular, educating
consumers about an entirely new product category may be
expensive, and a great deal of change may take place early in a
technology’s existence. Fast followers —those who come in after a
first mover—may be able to take advantage of the fact that you’ve
blazed the trail, then move quickly to supersede you.

• Those who move first may also have to make certain commitments
that can become rigid and difficult to change. First movers who
have had initial success may become complacent or experience
organizational inertia and may not be able to change as the market
begins to evolve.

• In addition, first movers may fall into the sunk cost trap. They
invest heavily in a particular technology or way of doing business,
and even if they start to get negative feedback, they can’t cut their
losses and shift strategy. They become over-committed to an initial
course of action and fail to adapt as markets evolve.

• Business researcher Greg Carpenter has noted that in many
cases, pioneers in a field are not very well funded. They create a
competitive game, but they’re unable to dominate it because their
resources are simply too limited.

Lecture 5: First Movers versus Fast Followers

• Despite the disadvantages first movers face, there are a number
of situations in which pioneering may be the right strategy: if the
expected life of a product category is very short, if the value of the
product is highly subjective or intangible, if brand is important, and
if the cost of imitation is high.

Economies of Scale

• Although we’ve said that economies of scale represent a source
of first-mover advantage, managers often grossly overestimate the
importance of this factor.

Costs per unit certainly fall over time as volume increases in many
businesses, but at some point, that curve begins to rise again. In
other words, the costs per unit eventually start to rise again as a
company gets too big,
complex, and bureaucratic.

Organizations grow to
a point at which some
inefficiency begins to be
built in, and smaller firms
then gain the advantage.

In many cases, firms
believe that bigger is
better because that has
been true in the past.
For example, scale was
a tremendous advantage
for General Motors for
much of the 20 th century.
But eventually, the firm’s
size became a liability.
GM became vulnerable,
because it wasn’t as
flexible and nimble as
other firms.

Large companies may sometimes
overestimate the importance of
economies of scale and fail to realize
the disadvantages they have relative to
start-ups and entrepreneurs.

gerenme/iStock/Thinkstock.

Learning Curves

• Learning curves can also be a significant source of first-mover
advantage, but in some situations, firms may be unable to hold onto
their learning or protect their intellectual property. The result is
what scholars call spillover effects —when the learning a firm has
achieved through experience spills out beyond the boundaries of
the firm. A second mover can capture those spillovers and can learn
from the first mover’s mistakes.

• This issue is particularly problematic in economies without strong
intellectual property protection, such as China. It’s also challenging
in situations where labor is very mobile and the knowledge that’s
being created cannot be easily protected through patents; such was
the situation in Silicon Valley, for example.

Network Effects

• It seems that if network effects exist, it would always make sense
for a firm to be first and get big fast. But think about social media.
If network effects are so crucial in that business, then how is that
Facebook was able to supplant early players, such as Friendster and
My space?

• Misiek Piskorski is a scholar who studied social media platforms,
and he concluded that for some certain networks, customers actually
prefer a non-crowded space. They want more users—there’s value
as others use the site—but if too many people use the site, the value
starts to turn negative.

• The example Piskorski gives is eHarmony. Users want to be on a
dating platform where there is a wide variety of potential partners,
but they don’t want too many other people on the platform because
that eventually causes competition.

• Felix Oberholzer-Gee at Harvard has also looked at possible
downsides to the network effect. In social media, the early company
Friendster pursued a get-big-fast strategy, trying to get customers in
both Asia and North America.

Lecture 5: First Movers versus Fast Followers

o But the Asian users generally weren’t interested in interacting
with American users and vice versa. Thus, spending money
to build two giant sets of individuals on the network on two
different continents didn’t actually add a lot of value.

o Friendster might have done better if it had focused on
building the network in only one region, rather than trying to
expend its resources to get big fast across two regions. That
waste of resources made the company vulnerable to others—
specifically, Facebook—which built a better platform with a
more focused strategy.

o Not only did Facebook focus on only one region, but it
also focused initially on only one customer segment—
college students. This focus created network effects but in a
bounded way.

Diminishing First-Mover Advantage?

• Might there be less first-mover advantage today than there was
several decades ago in business? As we’ve seen, incumbents seem
to get toppled much more readily, and firms face much shorter
periods of time during which they’re able to achieve advantage and
hold onto it.

• Some scholars have looked at platforms where users can sign on
across multiple platforms and move their contacts easily. They have
one profile that they can use on multiple networks and can move
with their friends en masse from one platform to another. In these
situations, users are not as locked in as they were previously, which
means that first movers have less of an advantage.

• One strategy for dealing with situations where network effects exist
has been described as the freemium business model. Flere, a firm
might give away a product for free but also have a premium offering
that requirements payment. This model is used by Linkedln, which

has two levels of membership. The model makes sense for a firm
that’s trying to build a network quickly and if there are low marginal
costs for adding new users.

• It’s important to think carefully about the pluses and minuses of
pioneering versus being a fast follower. Understand the sources of
first-mover advantage and the limitations of those advantages. As
an entrant or a follower, exploit the weaknesses in a pioneer’s first-
mover status, in short, don’t buy the conventional wisdom: Being
first is not always as advantageous as we think it is.

Suggested Reading

Anderson, Free.

Coughlan, “Leader’s (Dis)Advantage.”

Shankar and Carpenter, “Late Mover Strategy.”

Shapiro and Varian. Information Rules.

Suarez and Lanzolla, “The Half-Truth of First Mover Advantage.”

Questions to Consider

1. What are the pros and cons of being the first mover?

2. Why do first movers not always succeed, even when learning curves and
network effects exist?

3. What are some examples of firms that have used network effects to
achieve competitive advantage?

Lecture 6: When Netflix Met Blockbuster

When Netflix Met Blockbuster

Lecture 6

I n this lecture, we’ll go back to 1999 and take a look at the retail chain
Blockbuster, which sold and rented videos. At the time. Blockbuster’s
mainstream customers were 30- to 45-year-old soccer moms, living in the
suburbs with their families and looking to rent new movie releases on VHS
tapes. In the same year, Netflix began offering its service, which allowed
people to rent movies through the mail by subscription. Its mainstream
customers were 18- to 29-year-old males who watched DVDs rather than
tapes and were interested in cult classics and independent films. In this
lecture, we’ll look at how Blockbuster reacted to the disruptive innovation in
the industry presented by Netflix.

Disruptive versus Incremental Innovation

• In 1999, Blockbuster’s market research probably revealed that its
customers wanted more copies of hit movies to be available in
stores. In response, the company began to guarantee just that—
that its stores would have new releases on hand to rent. The “new
release” section of the stores changed from a small area to an entire
wall and, later, to the entire perimeter of the store.

• However, the potential Netflix customer—the young men who
liked cult classics—were dissatisfied with this change. There was
no room on the shelves for old movies because new releases had
crowded them out. Further, these customers disliked late fees
because they didn’t have much money and because they liked to
keep movies longer and watch them multiple times.

• In making the change, Blockbuster pursued incremental innovation.
The company conducted focus groups and surveys among its
mainstream customers and, in response to their suggestions, offered
a small improvement in its service. But Netflix presented a disruptive
innovation —a fundamentally different product, service, or business
model—that undermined Blockbuster’s competitive advantage.

• As we’ve said, there are three main external threats to competitive
advantage: imitation, substitution, and holdup. In many ways,
substitution is the most serious of these, and that’s the threat that
Netflix presented. Substitution is often hard to foresee and, perhaps,
even harder to respond to.

• Many years ago, the economist Joseph Schumpeter wrote about
the need to look beyond your direct rivals when thinking about
the principal threat to your competitive advantage. He said that
attention is often focused exclusively on competition within a rigid
pattern of invariant conditions, methods of production, and forms
of industrial organization. But in reality, that kind of competition is
not as threatening as the competition from a new commodity, new
technology, or new type of organization.

• Earlier in his academic career. Harvard Business School professor
Clay Christensen traced the evolution of the disk drive industry
from 1976 through 1992, watching as a series of technological
innovations came to market and observing what happened to the
players in that market.

o From a technological perspective, the physical size of the
disk drive shrank dramatically during that time. Moreover,
the cost per megabyte of storage dropped substantially. In this
situation, Christensen observed that the incumbent leaders in
one generation of technology often were not able to maintain
their leadership in the next technological generation.

o Christensen argued that the incumbent players were intent on
pursuing incremental innovation—minor improvements to
the attributes that mainstream customers valued. In contrast,
disruptive innovators introduced a different package of
attributes from the ones that mainstream customers typically
valued. Indeed, disruptive innovators often performed
significantly worse on certain attributes that mainstream
customers valued highly, but their performance trajectory was
steep for the disruptive innovations.

Lecture 6: When Netflix Met Blockbuster

o In our example, Netflix wasn’t focused on such attributes as in¬
store experience or availability of new releases. In fact, Netflix
performed significantly worse on some of these attributes. But
Netflix was focused on renting older movies, and it came up
with a new way of doing business for that purpose. Initially,
Netflix didn’t perform well, but the company improved at a
rapid rate.

Challenges in the Face of Disruption

• In the face of disruptive innovation, incumbent firms often struggle
a great deal. According to Christensen and his coauthor, Joseph
Bower, the sources of incumbents’ problems are traditional market
research and traditional resource allocation processes.

Of course, traditional market
research focuses on gathering
feedback from customers. But
customers tend to think in terms
of incremental improvement—
minor adjustments a firm might
make to increase customer
satisfaction. Customers don’t
think in terms of totally new
ways of doing business.

In addition, incumbent firms
tend to have rigorous financial
criteria for allocating their
investment dollars. If someone
has a new idea, the firm looks
to cost-benefit analysis or
return-on-investment figures

to determine whether the idea makes economic sense. With an
idea that’s completely new or involves cutting-edge technology,
it’s difficult to come up with precise financial models. Large firms
also often fear that a new product or service will cannibalize an
existing one.

As Blockbuster learned,
conducting market research
with typical customers tends to
result in incremental innovation;
it doesn't help you foresee
disruptive innovation.

Stockbyte/Thinkstock.

• Another reason that incumbent firms struggle so much with
disruptive innovation is mental lock-in. Such firms get stuck in a
particular mental model of how to make money in their markets
and don’t consider alternatives that may be introduced by
disruptive innovations.

o For example, Polaroid was built on a deeply imbedded razors-
and-blades business model: Sell cameras to people at relatively
low cost, and they will buy film for many years to come. In
fact, Polaroid made most of its money on film.

o Many people believe that Polaroid simply failed to recognize
the revolution in digital photography, but that’s not the case.
Substantial research and development activity in digital
technology took place at Polaroid, but senior executives were
strongly resistant to giving this new technology the resources
needed to go to market because they were wedded to the old
business model.

The Long Tail

• The long tail is an idea put forth by Chris Anderson, the former editor
of Wired magazine. Anderson looked at the largest brick-and-mortar
music retailer in the United States, Walmart, which at the time of his
study, carried about 4,500 unique CD titles, or about 55,000 songs.

• Most of the activity in the music section of Walmart stores centered
on the hits. The top 200 albums—about 5% of the albums in the
section—accounted for 90% of Walmart’s music sales at any given
point in time. In this, Walmart’s music business exhibited the usual
pattern found in hit-driven businesses (books, movies, and music)
before the Internet.

• But Anderson noticed something different when he looked at some
of the emerging technologies of entertainment, such as Rhapsody,
a digital music service. Rhapsody carried more than 1.5 million
songs, and a big chunk of its sales also came from hit songs. But
Rhapsody also reported that songs ranked as low as 900,000 on its
popularity charts were streamed at least once per quarter.

Lecture 6: When Netflix Met Blockbuster

• Anderson noticed the same phenomenon in other new economy
firms: 21% of Netflix’s revenue was generated from movies not
available at Blockbuster; 40% of Rhapsody’s revenue was generated
from music not available at Wahnart; and 25% of Amazon’s book
business was generated from books not available in brick-and-
mortar stores. The long tail is the idea that a great deal of revenue
can be generated from products that are low in popularity.

• According to Anderson, traditional entertainment retailers made
all their money from the hits. Hybrid retailers, selling physical
goods through catalogs or online sites, could make money from
many more items because they could stock more of those items
in a distribution center than in a physical store. And purely digital
retailers could make money on an even wider array of products.
No matter how low in popularity an item is, the cost to add it to
a digital library is so low that a digital retailer can make virtually
any song or movie available even if there is only one customer
who wants it.

• Anderson also noted that social networking, customer reviews,
playlists, blogs, and other forms of social media drive demand for
these niche products, rather than mass marketing. Beyond that,
digital retailers can collect information about customers and build
sophisticated algorithms to create customized recommendations
for them. Netflix, for example, built a huge customer database,
and the predictive power of its algorithms was quite high. When
Blockbuster tried to catch up, it wasn’t able to capitalize on the
same network effect.

Reacting to Disruptive Innovation

• In his work on disruptive innovation. Clay Christensen argued
that incumbent firms must create a separate unit or subsidiary to
react to an upstart entry and wall this unit off from the mainstream
business. This separation is necessary because without it, the
mainstream business will squash the innovation in an effort to
protect its profit margins.

• Some have critiqued Christensen’s theory of disruptive innovation,
and in fact, it may be an overused concept. It’s a good descriptive
tool but not necessarily a good predictive one. In addition,
Christensen focuses on the idea of incumbent firms missing a
disruptive threat, but he doesn’t address the misguided investments
firms can make when they misperceive a threat. Creating a new unit
to cope with a threat may not always be wise.

• It’s also important to consider the competitive advantage that comes
from an integrated system of activities. If a firm creates a separate
unit to go after a new idea, will it still have an integrated system of
activities, or will the firm become disjointed?

Suggested Reading

Anderson, The Long Tail.

Christensen, The Innovator’s Dilemma.
Lepore, “The Disruption Machine.”

Questions to Consider

1. How do resource allocation processes in large organizations stifle
radical innovation?

2. How have many innovators capitalized on the long-tail phenomenon to
build successful businesses?

3. Why has the theory of disruptive innovation become so widely embraced
and, perhaps, misused at times?

Lecture 7: Anticipating Your Rival’s Response

Anticipating Your Rival’s Response

Lecture 7

I n this lecture, we'll try to understand competitive dynamics in more
detail. As we’ll see, successful firms are able to put themselves in the
shoes of their rivals, anticipate how those competitors will react, and
use that information to help plot more effective strategies. In particular,
we’ll look at three well-known historical examples of competitive dynamics
in the business world: the story of NutraSweet and its reaction to a new
entrant in the market for artificial sweeteners, the case of the upstart Irish
airline Ryanair that competed against two dominant incumbent players, and
Blockbuster’s reaction to Netflix.

Analyzing Competitors

• Analyzing competitors is a multifaceted task that starts with
looking at their past and current strategies, understanding what
they’re trying to accomplish, and identifying how they’re trying to
position themselves in the marketplace. It also involves trying to
understand their goals. What specific financial targets and market-
share goals are they trying to achieve? How are they trying to
advance the objectives of their shareholders, satisfy their customers
more effectively, and keep their employees motivated and engaged?

• It’s also important to understand your competitors’ capabilities and
weaknesses. What is world class about their production, distribution,
and research and development, and where do they lag behind?

• Perhaps most importantly, you need to try to get inside the heads
of the executives in a rival firm. What industries are they from,
what companies did they work for in the past, and how might
those experiences shape their decision making? Where have they
succeeded in the past, and where have they failed? Is there a certain
formula that has worked for them in the past that they are likely to
go to again in hopes of achieving another success?

• Anticipating a competitor’s actions and potential responses to your
actions means understanding four factors:

o First, you must understand the economic and financial
incentives of your competitors—the costs and benefits of a
particular action.

o Second, you must look at the competitor’s noneconomic
motives, such as making itself a more attractive workplace or,
perhaps, forsaking profits in the short term to achieve a more
dominant position in the marketplace.

o The third factor to understand is the biases that may affect
your rival’s behavior. For example, is your competitor falling
into the sunk-cost trap, that is, escalating its commitment to a
course of action even if that action is failing?

o Finally, you need to understand the broader context in which
your rival operates. What political and historical factors may
affect the rival firm’s responses or shape its actions?

Economic Motives

• To understand a rival’s economic motives, a simple application of
game theory may be helpful. In game theory, one player tries to
predict what an opponent might do in various circumstances and
bases his or her strategy on that prediction.

• Many researchers have applied game theory to the scenario of
an entrepreneur moving into a new market and confronting an
incumbent player. Flere, the entrant faces a simple choice: whether
to move into the market or not. The incumbent also faces a choice:
whether to respond aggressively or to accommodate, perhaps
even relinquishing a small amount of market share in hopes of
maintaining its current pricing, marketing spend, and so on.

• Applying game theory, a new player coming into a market might
anticipate that the incumbent would be reluctant to fight a price
war, which would mean sacrificing profit by cutting revenue

Lecture 7: Anticipating Your Rival’s Response

dramatically and, perhaps, saving only a small amount of market
share. The better course for the incumbent would be to give up a
small piece of the market in exchange for maintaining its current
prices. In this situation, the new entrant might conclude that entering
the market is a good move. In contrast, if the entrant believes that
the incumbent will retaliate aggressively, then entering the market
might not be affordable.

• The idea here is to look forward and reason back. Game theorists
call this type of thinking backward induction. Ask yourself what
your rivals will do in the future based on your actions now. From
the answer to that question, you decide what to do today.

• Game theory can be helpful for thinking about the potential
responses of competitors to your choices, but it’s limited in some
ways. The real world is different than the realm of game theory
because the actors may not be completely rational—they may not
care only about maximizing economic profits.

Netflix and Blockbuster

• In 1999, Netflix entered the movie rental market, confronting the
incumbent, Blockbuster. In response, Blockbuster had a choice:
whether to fight the new player or accommodate.

• Recall that Netflix came into the market with a different pricing
model than Blockbuster. Netflix charged a monthly subscription
fee, rather than per movie, and it didn’t charge late fees. Thus,
one important decision that Blockbuster had to make early on was
whether to cut its late fees, which generated at least $300 million
per year for the company.

o Keep in mind that in its first few years, Netflix had only a few
hundred thousand subscribers, while Blockbuster had millions
of customers.

o For Blockbuster, cutting late fees would destroy the entire
profitability of the firm, while saving only a tiny slice of market
share. In this situation. Blockbuster chose to accommodate,
keeping its late fees and preserving its profitability, while
ceding some customers to Netflix.

• In making this decision, Blockbuster’s projection was that Netflix
was a niche player that would never become mainstream. Of
course. Blockbuster was wrong. The company eventually had to cut
late fees, but it took years to reach that decision.

Rynair and British Airways

• In the 1980s, when Ryanair entered the European airline industry,
it probably believed that British Airways would not cut its prices
because doing so would result in a significant hit to the incumbent’s
profits. At the time, British Airways charged IR£166 for the
London-Dublin ticket, while Ryanair planned to charge IR£98. A
price war would mean a substantial drop in revenue and profitability
for the incumbent.

• Keep in mind, too, that the slice of the market Ryanair sought was
tiny. In fact, the company originally had only a few small planes
and planned to make just four round trips per day between London
and Dublin.

• British Airways faced the choice of destroying its profitability by
cutting prices dramatically for that route or giving a few seats to
Ryanair and maintaining its pricing. But British Airways also had
to think about the entrant’s intentions: Will Rynair grow? Will it
add capacity, and if so, what effect will that have on the market?
Further, if British Airways accommodated Ryanair, would other
new players try to come into the industry?

Lecture 7: Anticipating Your Rival’s Response

Lessons for Incumbents and Entrants

• Incumbents can learn a number of important lessons from

such situations.

o First, you don’t want to min the whole market just to save a
small slice. But it’s also true that you may be able to identify
and focus on the customers who are most likely to defect to
the new entry. In that situation, you could cut prices or market
aggressively to one segment of customers but maintain higher
prices for others. Such a strategy would allow you to attack
without destroying your own profitability.

o You should also consider the signals you send by your
responses to new entrants. Perhaps fighting aggressively will
deter other entrepreneurs from entering your segment.

o Finally, you should think about how fast entrants may grow.
Is this upstart a niche player, or is it focused on taking over
the market?

A smart way to analyze the competition is to ask your management team to role-
play how a competitor might respond to your firm’s actions.

• Potential entrants should also think about a range of factors that
might prompt incumbents to make aggressive moves.

o Is this a slow-growth market? If so, the incumbent might fight
hard to preserve its customers.

o Is this a commodity product? If a product is not highly
differentiated, an incumbent might resort to price as its only
competitive weapon.

o Does the incumbent have high fixed costs relative to marginal
costs? If so, it might respond aggressively simply to keep its
capacity utilization high to cover fixed costs.

o What kind of resources does the incumbent have to wage
a battle?

o How has the incumbent reacted when other companies have
entered the market?

o Can the incumbent target its fight? Will it have to cut prices
across the board, or can it lower prices only for a segment of
customers who are most likely to defect?

NutraSweet and Holland Sweetener

• In the 1980s, NutraSweet was the dominant player in the artificial
sweetener market, but the company’s patents were about to expire,
and others were looking to enter the market.

• A potential new entrant, Holland Sweetener, made the mistake of
not understanding NutraSweet’s powerful cost advantage. In other
words, the artificial sweetener industry was highly influenced by
economies of scale and a substantial learning curve, and NutraSweet
had the advantage in these factors. For Holland Sweetener, that
meant that NutraSweet could fight aggressively, cutting its prices
significantly while still making money.

Lecture 7: Anticipating Your Rival’s Response

• Holland Sweetener also failed to apply game theory to understand

NutraSweet’s relationship with its two largest customers, Coca-

Cola and Pepsi.

o Holland figured that Coke and Pepsi wouldn’t want to be
entirely dependent on NutraSweet and would shift some of
their volume over to a new entrant in the market, especially if
they were offered an attractive price.

o But Coke and Pepsi were caught in game theory’s classic
prisoner’s dilemma: It would have been in each company’s
interest to switch some volume and get a better price from
Holland, but neither wanted to move first. Each company
believed that if it changed an ingredient, its rival would argue
to customers that the taste of the product had changed.

o For this reason, NutraSweet was able to retain its customers, and
Holland never made money in the artificial sweetener market.

Suggested Reading

Coughlan, Freier, and Kaiho, “Competitor Analysis.”
Dixit and Nalebuffi The Art of Strategy.

Rivkin, “Dogfight over Europe.”

Questions to Consider

1. Why is game theory useful in conducting competitor analysis?

2. Why do we have to go beyond thinking about the short-term economic
motives of our rivals?

3. Why might incumbent firms retaliate aggressively against a new entrant,
even at a significant short-term financial cost?

Why Did Disney Buy Pixar?

Lecture 8

T he Walt Disney Company competes in a number of businesses,
including theme parks, a film studio, cable television channels, hotels,
retail stores, consumer products, and more. Disney is a multi-business
unit corporation, and each of its business units competes in a different
product market. Thus far, we’ve been discussing strategy on the business
unit level. How does a company gain advantage over its rivals in a particular
product market? in this lecture, however, we’ll turn to corporate strategy,
asking the question: In what markets does a company choose to compete?
With a multi-business unit corporation, such as the Walt Disney Company,
why has the firm chosen to build a particular portfolio of businesses?

Horizontal and Vertical Integration

• With horizontal integration, a company chooses to compete
in multiple product markets in the hopes of achieving some
integration or synergy across those business. Horizontal integration
can be divided into two categories: related diversification and
unrelated diversification.

o Of course, related diversification applies when a company
appears to be competing in related product markets, where
there are apparent synergistic possibilities. Examples include
Disney and Procter & Gamble.

o Unrelated diversification refers to a situation in which a
company appears to be competing in markets that don’t have
much to do with one another. Examples here include General
Electric and the Virgin Group.

• With vertical integration, the company isn’t competing in multiple
product markets. Instead, it focuses on one particular product
market and competes along multiple links of the supply chain.
Vertical integration can also be divided into two types: forward
integration and backward integration.

Lecture 8: Why Did Disney Buy Pixar?

o Backward integration refers to a company that produces its
own components or raw materials.

o Forward integration refers to a company that operates its own
distribution or retail store network.

• In evaluating corporate strategy, we ask two fundamental questions
about each of the businesses that are part of a firm’s portfolio: (1)
Is each business better off as part of the corporation than it would
be by itself? (2) Does each business unit within the corporation
outperform comparable focused companies—those that compete in
only one product market?

Related Diversification

• Related diversification is focused on the idea of synergy, or what
economists call scope economies. The related diversification
strategy tries to achieve scope economies among businesses
competing in similar product markets. Put another way, with a
related diversification strategy, the firm tries to share resources or
capabilities across multiple businesses, whether those resources are
distribution channels, sales
forces, R&D facilities, or
factories. In Disney’s case, the
company shares its characters
across multiple businesses,
leveraging them to enhance
the value of its television
shows, theme parks, and
consumer products.

• Put another way, economies
of scope exist when each
business unit enjoys either a
stronger willingness to pay
or lower costs because of its
cooperation with sister units.

The related diversification

Disney believes that its theme
parks are somehow more valuable
as part of the Disney family than
they would be as an independent
company.

Digital Vision/Thinkstock.

strategy is all about strengthening the competitive advantage of
each of the business units, making it better off than it would be on
its own.

• Disney’s theme parks, for example, seem to enjoy higher willingness
to pay than competing theme parks largely because Disney’s
characters are incorporated into the theme parks in multiple ways.

Specialized versus Fungible Resources

• Disney is a powerful example of a company that has leveraged a set
of resources and capabilities into a number of different businesses.
In particular, Disney’s characters are valuable resources because
they are highly durable and difficult to imitate. How can a firm
leverage such valuable resources across multiple business units?
To answer that question, we need to think about specialized versus
fungible (general) resources.

• Examples of highly fungible resources or capabilities include
brand management expertise, innovation, and risk management—
fairly generic capabilities that could apply widely across
a range of businesses. A highly specialized capability might be
a patented product formula or specific engineering expertise in a
narrow discipline.

• A fungible capability can be transferred easily across lines of
business. But if it’s too general, it won’t provide substantial
competitive advantage. Highly specialized capabilities can
convey powerful competitive advantage, but they may not be as
widely applicable.

• In the 1980s, when Michael Eisner arrived at Disney, the
company’s core capabilities revolved around animated character
development and deployment—highly specialized capabilities that
constrained growth in some ways. But Eisner redefined Disney’s
core capabilities more broadly—as creativity management. This
definition enabled him to justify the move into a broader range
of businesses.

Lecture 8: Why Did Disney Buy Pixar?

o Interestingly, in Eisner’s first decade at Disney, when he
was focused on leveraging the characters, the company did
incredibly well. But as he stretched the definition of what
Disney was good at—moving farther away from its core
business into sports teams, films for adults, and so on—
performance started to suffer.

o Bob Iger, the chief executive who took over from Eisner,
appears to have returned to the formula of leveraging characters
and has had great success financially.

Transaction Costs

• Just looking at synergy alone is not enough in thinking about
whether multiple businesses should be under one roof. It’s also
important to ask whether the businesses should be merged or can
act as partners.

• There is some cost to bringing two companies together under
one roof—costs related to additional bureaucracy, costs of going
through a merger, and so on. In some cases, it may be wiser to keep
the companies independent but cooperate and achieve economies of
scope. Consider this issue is terms of Disney’s hotel and consumer
products businesses.

o Disney owns many hotels near its theme parks, but it outsources
production of its consumer products, such as toys and games.
Consumer products are synergistic with the rest of the Disney
family, but the company has chosen not to manufacture those
products in house. What’s the difference between the hotel
business and consumer products?

o One major difference is that the hotel business offers more
of an indefinable experience that’s created by Disney, while
consumer products lend themselves to a clear design that can
be communicated to an outside manufacturer.

• This issue relates to a question asked by Novel Prize winner
Ronald Coase in a paper called “The Nature of the Firm”: Why
do firms exist? If markets are such a great way to coordinate
economic activity, why is not all activity conducted through the
marketplace with small firms run by entrepreneurs? Why do we
need large organizations?

o Coase refined the questions as follows: Should economic
activity be coordinated by the market mechanism or by
intra-firm organizational structures and processes? In other
words, should you contract with an outside supplier to make
components, or should you build and run your own factory?

o Coase’s answer was that it’s necessary to look at the transaction
costs associated with organizing certain economic activities.
For a company deciding whether to contract with an outside
manufacturer or handle its own manufacturing, the question
becomes: Under which arrangement will the transaction costs
be lower?

o For Disney, it would be difficult to train personnel from an
outside hotel chain to create the guest experience that Disney
seeks; thus, the firm owns its own hotels and monitors the
interaction between employees and guests closely. But
consumer products can be monitored from afar, which means
that the company can outsource manufacturing to get the
best price.

• Three factors drive transaction costs: uncertainty, frequency, and
asset specificity.

o Market coordination becomes very difficult and costly when the
potential arises for opportunistic behavior, and such potential
exists when economic actors invest heavily in transaction-
specific assets—in other words, when factors of production are
highly specific to the other party.

Lecture 8: Why Did Disney Buy Pixar?

o Imagine an oil refinery that has only one way to pump its oil
to customers—from a pipeline attached to the refinery. The
pipeline has only one use—to pump the oil from that particular
refinery. Could the refinery and the pipeline be independent
companies and contract with each other? The answer is no.

o Each asset is completely specific to its partner asset; therefore,
the two are totally dependent on each other. Problems could
arise if one partner reneged on the contract or tried to get a better
price from the other. Their codependence makes it difficult for
them to operate peacefully through the marketplace; for this
reason, the two should operate as one firm.

• Of course, the choice is never simply to own or to contract with an
outside supplier. There is a spectrum of choices in between those
two options, such as a joint venture, strategic alliance, franchise
or licensing arrangement, and so on. Two companies that have the
ability to cooperate and achieve synergy may do so as independent
companies, through some kind of alliance, or through a merger.

• To close this lecture, let’s think about asset specificity and
codependence in the context of Disney and its acquisition of Pixar.
o When Pixar was making its first feature film, Toy Story , the firm

approached Disney to act as distributor for the movie. Disney
agreed under the condition that it would retain the characters
that Pixar developed and be able to use them in sequels, in the
theme parks, and so on, even if Pixar eventually went on to
work with another studio.

o A decade later, Pixar had achieved remarkable success, but
Disney Animation was struggling. Pixar threatened to go
to another studio but ultimately didn’t because of the earlier
agreement that Disney would retain the characters.

o In the end, Disney acquired Pixar because the two firms had
become codependent. They couldn’t work together through
the market; to achieve synergy, they had to come together
in a merger. Today, the Pixar characters are leveraged in the
same way that other Disney characters are across a range of
businesses. Pixar was more valuable as part of the Disney
family because Disney could fully exploit the value of those
characters in a way that few other firms could do.

Suggested Reading

Coase, “The Nature of the Firm.”

Collis and Montgomery, Corporate Strategy.
Williamson, Markets and Hierarchies.

Questions to Consider

1. Why do firms diversify, putting multiple business units under one
corporate parent?

2. What alternatives exist to horizontal and vertical integration?

3. Why must we consider transaction costs when determining the
appropriate corporate strategy?

Lecture 9: The Diversification Discount

The Diversification Discount

Lecture 9

C onsider two historical corporations that used to be very successful:
Fortune Brands and Sara Lee. Fortune Brands was a large, diversified
firm that competed in three segments: golf, liquor, and home
hardware. In addition to producing baked goods, Sara Lee owned a chain of
supermarkets, the Coach handbag company, Jimmy Dean meats, and other
businesses. As we saw in the last lecture, Disney is a related diversified firm
seeking to pursue synergies across product markets. In contrast, Fortune
Brands and Sara Lee are two classic examples of unrelated diversification.
In this lecture, we’ll look at why these firms assembled the portfolios they
did and why they later sold off these divisions and became much narrower
in focus.

Analyzing Diversified Firms

• When looking at a diversified firm, analysts and investors compare
its market value to its breakup value —that is, the amount each of
the firm’s divisions would be worth independently. Analysts try to
learn whether the sum of those amounts would be more or less than
the value of the whole company.

• A diversification discount results when the whole is worth less than
the proposed sum of the parts. Unfortunately for many diversified
firms, particularly unrelated diversifiers in the United States, it’s
often the case that the whole is worth less than parts, which is why
we’ve seen many corporate breakups in the last few years.

• Research from academics has also demonstrated that firms that
focus on one product market tend to do well in the United States.
Studies have shown that increases in focus tend to be followed by
stock price increases, and decreases in focus are often followed
by stock price decreases. Further, both spinoffs and their original
parent companies tend to outperform the overall stock market after
the separation of the two.

• All this financial evidence has proven to be a powerful rationale
for companies to slim down and for fewer companies to pursue a
strategy of unrelated diversification. However, it’s also important
to look at each company individually to understand its strategy.
In some cases, a company’s management may argue that the firm
is pursuing a related diversification strategy, while investors and
analysts may think that its business units are unrelated.

Risks of Unrelated Diversification

• There are four invalid reasons for diversification.

o The first of these is to diversify risk. Management may plan
to have some businesses in a firm’s portfolio that tend to do
well in a strong economy and others that are counter-cyclical.
When one of these businesses is doing well, the idea is that
it would offset others that are experiencing difficulties. But
diversifying risk is an invalid reason for a company to pursue a
diversification strategy.

o A second invalid reason for diversification is known as
cross-subsidization —that is, having a portfolio of seemingly
unrelated businesses at different stages of the business life
cycle. Businesses using this strategy are taking the cash that’s
being generated by profitable but mature businesses and using
it to fund growth in newer, high-growth industries.

o Businesses also sometimes pursue unrelated diversification
when they are looking for revenue and profit growth because of
problems in the core business.

o Finally, some companies look to unrelated diversification in an
effort to manipulate the stock markets. They try to enhance the
valuation of a business that is, perhaps, mature and not growing
by acquiring a newer, higher-growth business.

• As individuals, we know it makes good sense to diversify our
investment portfolios, but individuals can diversify much more
effectively and inexpensively than companies can. The external

Lecture 9: The Diversification Discount

capital market does a much better job of moving resources around
and valuing opportunities than the internal market. In a sense, we
can say—and research confirms—that a manager at the top of a
corporation is not as smart as the crowd—the entire external market.

• Cross-subsidization—taking money from mature businesses and

funding new opportunities—came from a concept introduced by
the Boston Consulting Group many years ago, the so-called BCG
Matrix. The basic matrix is shown below.

Slow Growth
Fast Growth

Low Market Share High Market Share

Dog

Cash Cow

Question Mark

Star

o BCG argued that an unrelated corporation could effectively
classify its business units by looking at two basic measures:
What kind of market share does the particular business have,
high or low? And how fast is the particular industry growing?

o In the matrix, a unit that is in a slow-moving industry and has
low market share is a dog. A unit in a slow-moving industry
with high market share is a cash cow; it generates a great deal
of cash and doesn’t have many opportunities to reinvest the
money in the business. A unit with a low share in a high-growth
industry is a question mark; it may or may not turn out to be
profitable. Finally, a unit with a high share in a high-growth
industry is a star.

o The idea of the matrix was to divest the dogs and milk the cash
cows. Take the excess cash from slow-moving industries and
invest in the question marks, even if they were unrelated to the
mainstream business.

o Again, this strategy presumes that managers inside the firm
can allocate resources better than the external market—that
they know where the best new opportunity is and they can

beat the market, blit this is very difficult to do. The wiser
course is often to give the excess cash back to the investors
and allow them to find the next opportunity. Let the question
marks get their funding from venture capitalists, angel
investors, or private equity firms rather than large, complex,
and mature corporations.

Governance Economies

• A company is pursuing unrelated diversification when it is operating
various businesses independently. Instead of trying to add value to
each of its businesses through the realization of synergies—as we
saw with related diversification—the idea here is to add value by
using a common management system across all the businesses. The
premise is that by having a single company controlling operations and
by transferring knowledge and best practices among the businesses,
all the businesses are managed better together than they could be
managed on their own—and they achieve governance economies.

• In this strategy, it’s purely management skill that is being leveraged
across businesses, not tangible resources and capabilities, such as
common distribution channels, common production facilities, and
so on.

• The classic example of a firm that has pursued governance
economies is General Electric. Throughout the 20* century, GE was
a high-performing stock. It was also clearly an unrelated diversifier,
operating a television broadcasting network, a jet engine business,
an appliance business, a lighting business, and others. However, GE
had a management system that spread across the businesses.

• Achieving governance economies is easier to pull off when there’s a
clear dominant logic or common theme across many businesses. For
many years, Emerson Electric was a successful unrelated diversifier,
but each of its businesses was in manufacturing, each was in a fairly
mature sector, each pursued a low-cost strategy, and each involved
a fairly mature technology. Thus, there were common threads, even
though the product markets were seemingly unrelated.

Lecture 9: The Diversification Discount

• Today, some have begun to question whether GE is still as
powerful as it once was in its exercise and execution of governance
economies. The spread of knowledge is easy and costless in
today’s economy, which means that other companies have adopted
GE’s best practices, and the company may no longer achieve the
governance economies it once did.

Unrelated Diversification around the World

• Research by Professor Tarun Khanna has shown that although
unrelated diversification may no longer make sense in developed
economies, such as the United Kingdom or the United States, the
picture may be different in emerging markets, such as India.

• To explain this difference, Khanna pointed to the idea of institutional
voids. He argued that a capitalist economic system requires the
effective functioning of certain institutions that enable parties to
enter voluntarily into mutually beneficial transactions. Institutional
voids occur when specialized intermediaries are absent.

• Intermediaries are economic entities that insert themselves between
a potential buyer and a seller in an attempt to bring them together
and help them engage in a mutually beneficial transaction.

o Consider, for instance, a firm pursuing a differentiation strategy
in an effort to achieve high willingness to pay.

o Certain intermediaries, such as Consumer Reports, may enable
potential buyers to confirm the quality of the firm’s products.
Other intermediaries, such as a market research firm, may
help the company assess consumer tastes. And still other
intermediaries, such as government regulatory agencies, may
certify high quality.

• There are many intermediaries that help make transactions work
in developed economies, such as that in the United States. In the
capital markets, there are auditors who verify financial statements.
In the labor markets, there are headhunting firms, certification

agencies, and business schools that help match candidates with
job opportunities. And through all the markets, there is a judiciary
system that operates to enforce the rule of law and property rights.

• But these intermediaries may not exist to the same extent in emerging
markets. And a large corporation—an unrelated diversifier—may
step into that institutional void to provide that value.

• Khanna has shown that the diversification discount we see in the
United States does not exist in, for example, India. Family business
groups that are in unrelated businesses are ubiquitous in India, while
we no longer see many unrelated diversifiers in the United States.
And the percentage of conglomerates trading at discount is below
50% in India, while it’s much higher than 50% in the United States.

• The House of Tata, or Tata Group, in India comprises more than 100
companies in seven business sectors, and it serves as a specialized
intermediary in a number of ways.

o For example, in an economy where there aren’t clear ways
to certify the quality of goods and services, Tata putting its
name on a product gives the Indian people confidence that the
product is of high quality.

o For companies that are part of the Tata family, talent for a
new business can be reallocated from an established business.
Capital can also be moved from a successful business into
emerging opportunities.

o By serving as an intermediary in these ways, Tata makes up
for inefficiencies in the market; therefore, it adds value to the
businesses in its portfolio in a way that an unrelated diversifier
could not in the United States.

• In the United States today, many of the unrelated diversifiers that
were successful three or four decades ago have been broken up.
The reason for this is that product, labor, and capital markets in
the United States have become much more efficient. In the 1960s,

Lecture 9: The Diversification Discount

the U.S. economy bore a closer resemblance to an emerging
market, with institutional voids and the opportunity for unrelated
diversifiers to fill them. Today, with far fewer institutional voids,
we see far fewer unrelated diversifiers.

Suggested Reading

Hitt, Hoskisson, and Ireland, Competing for Advantage.
Khanna and Palepu, Winning in Emerging Markets.
Stewart, The Quest for Value.

Questions to Consider

1. What are some flawed reasons for engaging in unrelated diversification?

2. Why might unrelated diversification make sense in certain emerging
markets?

3. What are the limitations and deficiencies of the BCG model of portfolio
management?

Forward and Backward Integration

Lecture 10

C onsider a firm that produces tractors, snow blowers, and other
lawn and garden equipment. Traditionally, this company has
distributed and sold its equipment through big-box stores, but
now, management is pondering a shift in strategy: Should the company
open its own chain of retail stores to exclusively sell its own products?
The rationale behind this shift is that opening stores will allow the
company to capture the profit margin currently being generated by outside
retailers. But the firm can’t capture the margin without spending a great
deal of money to execute the new strategy. As we’ll see in this lecture, a
company must consider whether forward or backward integration makes
economic sense.

Types of Vertical Integration

• Vertical integration comes in two forms: backward integration,
which means that a firm produces its own raw materials or
components, and forward integration, which means that a firm
distributes its own products.

• Apple and its store network represent a classic example of forward
integration. Other companies that use this strategy include Ducati,
an Italian motorcycle company; Disney; and Fresenius, a company
that makes dialysis equipment.

• Apple also engages in backward integration by designing, building,
and selling its own operating system. Weyerhaeuser is another
company pursuing a strategy of backward integration; the company
manufactures paper products and owns its own forests.

Lecture 10: Forward and Backward Integration

Disney’s Integration Decision

• The story of Disney’s retail stores illustrates a situation in which
a strategy of vertical integration may have made sense at one
time but, perhaps, became more questionable as different players
emerged in the toy retailing business.

• During the 1980s, Disney launched retail stores that initially
prospered, but around the beginning of the 21 st century, the chain
began to struggle financially. Ultimately, Disney struck a deal with
Children’s Place, a children’s apparel retailer, to take over the
operation of Disney stores. After several years, however, Children’s
Place chose to terminate the agreement and turn the stores back
over to Disney.

• Disney now faced an important choice: Should it try to operate and
manage the stores or shut them down? Times had changed since
Disney began its forward integration strategy. People now bought
toys on the Internet or from large retailers, rather than independent
toy stores. Disney decided to keep the stores, putting Jim Fielding
in charge of the effort. He launched a redesign of the stores, with
the goal of making them more of an experience that might raise
willingness to pay.

• Disney’s model here was the American Girl stores, which are
deeply experiential. Girls go to the stores not only to buy dolls but
also to get dolls fixed in the “hospital” if they’re broken, to have
lunch with their dolls, to get their dolls’ hair done, and so on. Of
course, such an experience requires a great deal of investment. A
firm must consider whether it can generate enough new revenue to
justify the expense.

• In Disney’s case, the company also had to walk a fine line between
creating too much of an experience, which might steer customers
away from its theme parks, and too little of an experience, which
might drive customers back to retailers where they could buy toys
less expensively.

• One happy medium that some companies have chosen in terms of
vertical integration is to operate flagship stores. With this approach,
a company might open only a few stores in selected locations. The
stores help build the brand and raise willingness to pay for the
products, but the company does not retail its products exclusively in
those stores or seek to operate a store in every mall in the country.

Rationale for Vertical Integration

• One reason for pursuing a strategy of vertical integration is to counter
holdup. Recall the oil refinery and the pipeline. They might vertically
integrate because each is so dependent on the other that they can’t
hold to a contractual agreement in an effective manner. Each is
concerned about the opportunistic behavior of the other party.

• Another reason to pursue vertical integration is that there’s some
synergy between businesses at different points in the supply
chain—perhaps economies of scale or scope.

• In addition, a company might backward integrate to secure access
to a crucial input. Or a company might pursue vertical integration
to foreclose access on the part of competitors—to stop them from
having easy access to a scarce input.

• A firm may also backward or forward integrate to offset the
bargaining power of suppliers or buyers or to elevate barriers to
entry. The more vertically integrated a firm is, the more expensive it
is for entrepreneurs to replicate that strategy.

• Yet another reason for pursuing vertical integration is to enhance
the ability to differentiate products in the market.

• Finally, vertical integration allows firms to acquire important
information that they might otherwise not have access to, such as
customer feedback.

Lecture 10: Forward and Backward Integration

Costs of Vertical Integration

• One of the major costs surrounding vertical integration is dulled
incentives. With a built-in customer, a vertically integrated
manufacturer may not have as great an incentive to perform well as
an independent entrepreneur.

• In addition, conflicts of interest may arise. A company that has
forward integrated may then compete with its own customers. This
is the case, to some degree, with Apple. The firm competes with
Best Buy, yet Best Buy is an important Apple customer.

• Vertical integration reduces a firm’s flexibility to change suppliers.
There are also higher fixed costs and management costs for
vertically integrated businesses. Exit barriers rise significantly for
vertically integrated businesses. Finally, a vertically integrated firm
may experience internal conflicts, especially around the issue of
prices charged by one component of the business to another.

Partial Integration

• As an alternative to full vertical integration, some Anns have
chosen tapered or partial integration. In this situation, a firm might
use both outside retailers and its own stores, or it might use both
outside suppliers and its own factories.

• One benefit of this approach is that it exposes in-house units
to outside competition, increasing incentives to maximize
performance. Partial integration also gives a firm more flexibility
and enhances learning because knowledge can be transferred
quickly from outside parties to internal units and vice versa.

• Strategic outsourcing might be considered one form of partial
integration. In many cases, outsourcing arrangements allow firms
to develop deep relationships, cultivating long-term partners but not
pursuing full vertical integration.

Declining Trends in Integration

• In recent years, there has been a dramatic decline in vertical
integration, particularly in developed nations in such industries as
computers and automobiles. The reasons for this decline can be
traced by to the transaction cost theory of Coase and Williamson.

• The transaction costs associated with using the market have
decreased significantly. In other words, a firm can outsource much
more easily today than it could 30 years ago. The web and easier
travel and communication around the world have enabled firms to
partner with others who may be quite distant.

Case Study: Zara

• A Spanish retailer named Zara has been wildly successful in recent
years while pursuing an interesting vertical integration strategy.
Zara produces a significant portion of its clothing in factories
it owns in North Africa and Western Europe. This approach is
different than Zara’s competitors, such as H&M and Gap, which
don’t produce any of their own products. These retailers outsource
all manufacturing to low-cost players in Asia or Latin America.

• Zara has pursued a strategy of following the great luxury apparel
companies. After new fashions from these companies hit the
runways, Zara produces its own similar designs quickly and in
small batches for its stores.

• Interestingly, Zara has used a partial integration strategy. It
outsources fashion basics, such as t-shirts, to low-cost manufacturers
in Asia, while producing other fashions that it wants to be able to
change quickly in house.

• Zara realizes a number of benefits from this vertical integration
strategy. It doesn’t end up with excess inventory if it makes a
wrong bet on a particular fashion trend. The company is also able to
change its product mix quickly. It doesn’t have to commit to buying
large quantities of clothing and, as a result, has fewer markdowns.

Lecture 10: Forward and Backward Integration

Capturing the margin is not a valid reason to pursue integration; a firm must be
able to add value by owning different parts of the supply chain.

• Of course, Zara’s labor costs are much higher than those of its
rivals, but the firm’s ability to have fewer and smaller markdowns
offsets the labor cost disadvantage. There are also tremendous
fixed costs associated with building and operating factories, as
well as significant exit barriers. At times, Zara has had to take
on debt in order to fund the building of its factories. Finally,
the company has had to accept lower asset turnover. It does not
generate the same use of assets and efficiency as a company that
outsources completely.

• Zara has not pursued the same strategy everywhere around the
globe. The company owns its own stores in Western Europe, but
in some countries, it has set up joint ventures or franchises to
operate stores.

• In writing about Zara, the journalist James Surowiecki articulates
many of the philosophies of strategy we’ve discussed throughout
these lectures on strategy. In particular, he notes that imitation of
Zara would be difficult because it’s an integrated system, not just a
collection of parts.

Suggested Reading

Ghemawat and Nueno, “Zara.”

Harrigan, Vertical Integration, Outsourcing, and Corporate Strategy.

Questions to Consider

1. What is an example of flawed logic used to justify vertical integration?

2. How do some firms achieve stronger competitive advantage through
vertical integration?

3. What are some of the pros and cons of pursuing a vertical integration
strategy?

Lecture 11: Mergers and Acquisitions—The Winner’s Curse

Mergers and Acquisitions—The Winner’s Curse

Lecture 11

M ergers and acquisitions are part of daily life in the business
world. It seems that almost every day we hear of a large
company acquiring a small one with an exciting new product
or two giant firms combining in a merger of equals. Unfortunately, there
are many instances when these deals do not work out; in some instances,
they even produce disastrous results. In this lecture, we’ll look at the
strategic logic behind mergers and acquisitions, the situations in which
they make sense, and the situations in which they might actually decrease
shareholder value.

Overview of Mergers and Acquisitions (M& A)

• A merger takes place when two firms come together to form a new,
combined entity. An acquisition takes place when one company
purchases another and takes charge. In some cases, two large
companies come together in what they term a merger of equals, but
in reality, there is no such thing as a merger of equals. In almost
every case, one management team takes charge and asserts its
authority over the managers in the other company.

• There is also an important distinction between friendly and
unfriendly deals. Of course, a friendly deal takes place when
one company acquires another and the selling party is accepting
of the deal. In a hostile takeover, however, the target firm is not
cooperative in the acquisition. The acquiring firm goes directly
to the shareholders and tries to convince them to sell, even if
management and the board of directors are against the sale.

• To understand how these deals work, suppose that the stock price
of a target firm is $X per share. The acquiring firm tends to pay
a significant premium over $X per share, sometimes 20% to 40%
more than the shares are currently trading at in the market.

o Given that premium, the acquiring firm must believe that
somehow the target firm will be more valuable as part of the
corporation than it was as an independent entity.

o In other words, the acquiring firm must believe that economies
of scope exist, and it has valued those synergies at the maximum
premium that it is willing to pay for the target company.

• Acquisitions result in high returns for the target firm’s shareholders,
but in many cases, the share price of the acquiring firm declines
slightly. This decline represents skepticism among investors that
the firm can realize the synergies. Keep in mind that an acquiring
firm must realize synergies in excess of the premium paid to get
control of the target firm, and that is a difficult challenge.

• Many deals don’t lead to long-run increases in shareholder value.
The synergies that are produced do not exceed the premium that the
acquiring firm had to pay. Part of the reason for this is that the target
firm is also estimating the synergies. The target tries to understand
the added value that will be created if it becomes part of a new
entity, and it tries to capture most of the value of those synergies
in the price it receives for selling the company. In many cases, the
result is that the acquiring firm ends up overpaying.

Valuing Target Firms

• An acquiring firm can use a discounted cash flow technique to
value a potential target—estimating the target’s cash flows moving
forward, then discounting those back to today’s dollars. As part of
that process, the acquiring firm is not only estimating the target’s
current financials but also trying to project the synergies into the
cash flows going forward.

• There are also other methodologies for valuing a potential target,
but the challenge with any of these techniques is that they often
include many assumptions that can vary widely depending on
who conduct the analysis. The conclusions of an analysis are also

Lecture 11: Mergers and Acquisitions—The Winner’s Curse

highly sensitive to just a few core assumptions, such as those about
expected revenue growth, operating margins, and the challenges of
realizing certain synergies.

• Another problem with these analyses is that not enough attention
is paid to the costs involved in achieving the expected synergies.
Polycom, a company that competes in the telecommunications and
video-conferencing business, tries to estimate anti-synergies in its
potential acquisitions—something most firms don’t do. Polycom
looks at the losses it might incur as it tries to bring two firms together.

The Winner’s Curse

• Richard Thaler at the University of Chicago has tried to explain
why bidders sometimes pay too much with an idea he calls the
winner’s curse.

o At an auction, bidders have some value in mind for an object,
but they don’t know the value that others have placed on that
object. The assumption at an auction is that the real value of
the object is closest to the average bid.

The winner’s curse is the idea that any winning bidder—at an auction or in the
acquisition of a business—inevitably pays more than the underlying real value
of the asset up for sale.

o Of course, the highest bidder wins the auction, but if the
underlying real value of the object is equal to the average bid,
the winner has overpaid. That’s the winner’s curse.

• In the business world, the winner acquires a company, but it has
paid more than the actual value for the company. The winner’s
curse is Thaler’s explanation for the fact that many deals don’t
generate positive returns for shareholders.

Cost versus Revenue Synergies

• Executives considering an acquisition typically focus more
on cost synergies than revenue synergies. In other words, they
look at the ways in which expenses will be reduced, instead of
thinking about opportunities to generate new sales if two firms are
brought together.

• Of course, it’s much easier to be explicit about cost synergies.
Executives can point to specific layoffs, plant closings, or
consolidations that will be executed. Revenue synergies tend to be
more nebulous. How can you prove, for example, that a merger will
open up new sales opportunities in a specific region?

The Principal-Agent Problem

• Typically, in a large, publicly traded corporation, ownership
and control are separated. Ownership is divided up among many
shareholders (principals), all of whom own tiny shares in the
company. At the same time, control rests in the hands of a chief
executive and his or her team (agents).

• Do the principals and agents have the same interests? The
shareholders want optimal profits to maximize the value of their
shares. The agent is also interested in profits, but he or she—
like all individuals—also seeks to maximize personal utility
and satisfaction. This might come in the form of monetary
compensation, executive perks, power, publicity, and so on.
Thus, executives are interested in a number of things that do not
concern shareholders.

Lecture 11: Mergers and Acquisitions—The Winner’s Curse

• The interests of the principals and agents can be aligned through
incentives and monitoring.

o For example, a company might give managers stock options
to make them part owners of the company, or managers might
be rewarded with bonuses for increasing profitability for
shareholders. At the same time, shareholders usually institute
a monitoring mechanism in the form of a board of directors.

o But neither incentives nor the board as a control mechanism
is perfect. Agency costs are the resulting misalignment that
remains even after good incentive systems and monitoring
devices are put in place.

• Flow do agency costs and the principal-agent problem explain
inefficient M&A activity? Many executives may be interested in
empire building, not just maximizing shareholder value. And the
board may not be in a position to effectively question the CEO’s
judgment, or the CEO may have control of the board.

Flerd Behavior

• Another explanation for M&As that go bad is herd behavior. In an
effort to avoid being fired, a CEO might take a risk-averse approach
to managing the company—an approach that entails copying other
leading competitors. The thinking here is as follows: If others are
vertically integrated, and you don’t pursue that strategy, you run
the risk of looking stupid if the strategy proves to be beneficial to
shareholders at rival firms. But if following the herd doesn’t work
out, you can point to the fact that all of your rivals did the same.

• The late 1990s saw a wave of deals in the entertainment industry.
But it seems unlikely that these deals occurred because each firm
involved independently concluded that vertical integration made
sense in the industry. It was probably the case that each executive
team saw others in the industry pursuing vertical integration and
decided to follow suit.

• In the early 2000s, the alcoholic beverage industry was also
involved in a wave of acquisitions. Interestingly, in cases where two
beer companies or two spirits companies came together, the deals
worked out, with both companies benefiting from clear economies
of scale and scope. But in deals that brought together beer, wine,
and spirits, the economies of scope were not as clear and the deals
didn’t work. Herd behavior was a large part of the reason that the
deals were launched in the first place.

Difficulties in Integration

• One of the challenges with any deal is that it’s often difficult to
integrate two or more companies. There may be obvious synergies
with the firms, but realizing those synergies may be difficult. Two
scholars, Philippe Haspeslagh and David Jemison, have done an
interesting study of this phenomenon.

• Haspeslagh and Jemison concluded that how a firm goes about the
acquisition decision-making process, how it does due diligence,
and how it approaches the other firm all have a significant impact
on the ability to integrate a company.

• Too often we see culture clashes and other friction that prevents the
acquirer from realizing expected synergies. Sometimes, problems
also arise when a firm that has had a great deal of experience buying
small companies suddenly tries to acquire a large one.

Global Mega-Deals

• Scholar Pankaj Ghemawat, an expert in international strategies,
has noted that a rule of three seems to have become conventional
wisdom in many industries. Executives come to believe that
ultimately, a certain industry may involve only three big players.
If consolidation is inevitable, the executives seek to execute a
merger or acquisition to secure a position for their firm as one of
those three.

Lecture 11: Mergers and Acquisitions—The Winner’s Curse

• According to Ghemawat, the assumption that the global economy
is a winner-take-all economy has become common wisdom, but
there’s no evidence to support that premise. The theoretical links
between the globalization of an industry and the concentration of
that industry are weak.

• Executives, then, need to break free of the biases that lead them
to pursue larger and larger deals. There are better, more profitable
strategies for dealing with globalization than relentless expansion.

Suggested Reading

Bruner, Deals from Hell.

Ghemawat and Ghadar. “The Dubious Logic of Global Megamergers.”
Gupta and Govindarajan, “Managing Global Expansion.”

Thaler, The Winner’s Curse.

Questions to Consider

1. Why do many M&As fail to deliver increased shareholder value?

2. Why do executives continue to pursue so many M&As despite the
spotty record of past performance for such deals?

3. What alternatives to M&As might a firm pursue, and what are the pros
and cons for these other options?

Launching a Lean Start-Up

Lecture 12

M any people have ideas for new products or services and would like
to try entrepreneurship at some point in their careers. In this final
lecture on competitive strategy, we’ll take a look at the challenge
of launching your own business. How can you apply the ideas from these
lectures on strategy to building and running a successful venture? And how
is entrepreneurship different than leading a large, complex organization?

The Marshmallow Challenge

• The marshmallow challenge is an exercise in which groups compete
to build the tallest freestanding structure using only uncooked
spaghetti, tape, string, and a single marshmallow. This exercise
has been run with many groups of people from different fields and
yields some interesting results.

• Recent graduates of business schools underperform the average on
this challenge, as do lawyers and CEOs. Engineers, architects, and
kindergarten students excel at the challenge,
o In business school, students are taught to plan, then execute.
They learn to set out goals and the means of achieving those
goals in as much detail as possible. In the marshmallow
challenge, that means coming up with the perfect design
on paper before trying to build the structure. Many business
school graduates don’t even touch the marshmallow until near
the end of the time allowed for the challenge.

o In contrast, kindergarten students tend to pick up the
marshmallow early on and start to play with it. In building
their structures, they engage in trial and error. Instead of a
linear plan-execute process, the kindergarten students do what
great designers and entrepreneurs do: They test, experiment,
and prototype.

Lecture 12: Launching a Lean Start-Up

o Tom Wujec, a designer who frequently runs this challenge, has
also found that CEOs do better when an administrative assistant
joins their team. Wujec argues that because the assistants are
good at facilitating work processes, they enable the team to
work together more effectively; the assistants help other team
members through a testing and prototyping process that leads
to a taller structure.

• Peter Skillman, the creator of the marshmallow challenge, once
said, “Enlightened trial and error succeeds over the planning of lone
genius.” This is true not just in building marshmallow structures but
in launching new ventures, as well.

The Lean Start-Up

• In the past, the approach to launching an entrepreneurial venture
was to conduct extensive market research, write a detailed business
plan, and construct pro forma financial statements. In recent
years, however, there has been a movement toward a new way of
launching a venture, the lean start-up model. This approach is more
iterative and less linear than the old one; it involves more learning
and adaptation.

• Eric Ries is one of the pioneers of the lean start-up methodology.
According to him, every start-up is a grand experiment that
attempts to answer a question. But that question is not: Can this
product be built? Instead, it’s: Should this product be built, and can
a sustainable business be built around it?

• This experiment, Ries says, is more than just theoretical inquiry;
it’s a first product. If it’s successful, it allows the entrepreneur to get
started with his or her campaign, enlisting early adopters, adding
employees to each further experiment or iteration, and eventually,
starting to build products.

• Notice that there’s an important distinction between this approach
and the experience of many entrepreneurs. An entrepreneur may
have a great product in mind, but Ries points out that a great product

concept is not a business. A business needs a business model,
including an understanding of which customers actually need the
product and what they need to get out of it. Meeting those needs
involves adaptation, which can be difficult for many entrepreneurs
if they fall in love with their own products.

• Ries articulates the notion of a minimum viable product (MVP).
You start by figuring out what problem needs to be solved. What
pain point is the customer experiencing? The starting point is not
your great idea for a new technology but the customers’ needs,
based on the frustrations they’re experiencing with current products
and services.

• From there, you develop an MVP, which is that version of a new
product or service that allows a team to collect the maximum
amount of validated learning with the least effort. The idea here is
begin to learn as soon as possible, then adapt, or “pivot,” shifting
your idea based on the learning that takes place.

• Here, it’s crucial not to belabor the planning process but to get
to that learning as soon as possible. In other words, pick up the
marshmallow early. Get an initial concept, prototype, or product
into customers’ hands and collect feedback.

• The goal of the MVP is to test certain hypotheses or propositions
related to what attributes customers care about, how they define
quality, and whether or not they are willing to pay a certain amount
for the product or service. These data allow you to determine, for
example, whether you can command a price that is sufficient to
cover your expenses.

• It’s important for entrepreneurs to get comfortable with the idea of
“good enough” in order to get the prototype into customers’ hands
as soon as possible and to listen to the feedback they receive.
You must be willing to put out a product that may not be perfect
and able to listen to people when they tell you what’s not perfect
about it.

Lecture 12: Launching a Lean Start-Up

The MVP Strategy in Large Firms

• It seems that many large organizations cannot pursue an MVP
strategy because it’s difficult for them to put a “good enough”
product into the marketplace. People who work in large
organizations are trained to have high quality standards, and the
organizations themselves are intent on protecting their brands.
Thus, to put out a product that’s less than perfect runs the risk of
harming the brand and damaging a firm’s reputation for quality.

• David Kelley, founder of the leading product design firm IDEO,
uses the idea of “failing often to succeed sooner” to drive the
innovation process at his firm. This notion is also crucial in the
context of entrepreneurship. Entrepreneurs must be willing to put
something out in the market that is a “failure”; they must be able to
listen to negative feedback and adapt.

o Again, we can see why large companies have a problem with
this. If you’re a manager at a large company and your initial
attempt at getting a new product into the marketplace is
a failure, you run the risk of damaging your career. For this
reason, managers in larger organizations tend to be risk averse.

o Further, the culture of large organizations is such that they’re
not tolerant of early failures that are simply part of the creation
process for new ventures.

• It’s important to note, however, that not all failure is acceptable.
Entrepreneurs and large companies should not spend inordinate
sums to launch new ventures; instead, aim for small experiments
and inexpensive prototypes that enable you to get feedback quickly
and improve.

Lean Start-Ups in Today’s Environment

• There’s an argument to be made that it’s easier to build and test
an MVP today than might have been possible years ago. The cost
of computer processing power has come down dramatically, and

open-source software is now
available that can help you
launch your business. Further,
access to capital and talent
has generally become easier.

The scholar Vivek Wadhwa
has done some interesting
research over the years on
start-ups, looking at many
of them in Silicon Valley,
in particular.

o He has noted that today’s
laptops have the same
processing power as
many computers that cost
millions of dollars in the
1980s. For storage, you once needed server farms and racks of
hard disks, but today, we have inexpensive cloud computing
and cloud storage.

o In short, it’s easier to run an experiment today. You can launch
a new venture without the need for a great deal of capital. As
entrepreneurs like to say, you can rely on fools, friends, and
family to get money and get a business off the ground.

There has also been an explosion in the number of start¬
up accelerators ; these are typically groups of experienced
entrepreneurs or venture capitalists who coach entrepreneurs in
launching new ventures.

o Start-up accelerators take applications and accept new ventures
into a cohort-based, residential program. The entrepreneurs live
and work at the location of the start-up accelerator for about 12
weeks, where they get assistance, counseling, and some seed
funding. In return, they typically give up a 6% equity stake to
the owners of the start-up accelerator.

Yelp pivoted from its initial
incarnation as a system for emailing
recommendation requests to
friends to an online review system
of restaurants and local businesses.

micha elj ung/iS tock/Th inksto ck.

Lecture 12: Launching a Lean Start-Up

o The 12-week program culminates in a demo day, where
potential investors are assembled, and the entrepreneurs get a
chance to pitch their ideas to raise funding.

Gaining Investors

• Venture capitalists often say that they invest in the team, not just
the product or the idea. Investors understand that most ventures will
have to pivot multiple times in the early days—the idea won’t be
right at first. Thus, they try to find entrepreneurial teams that are
open to new ideas, will listen to feedback, and are willing to adapt.

• In seeking investors, entrepreneurs must also have a business model,
not just a product. As we’ve seen in these lectures, competitive
advantage doesn’t come from having the best technology or
being the first mover in the marketplace. It comes from having an
integrated system of activities that delivers value to the customer.
That value must be enough to generate returns for investors and
provide consumers with some surplus, some value beyond what
they paid for the product.

• As an entrepreneur, you must ask yourself a number of questions
about launching a new venture: What customer pain point are you
trying to alleviate? What is your business model? Who is on your
team? Are you willing to adapt and pivot? And perhaps the most
important question is this: What makes you different, and can
you sustain that position? With the ideas you’ve learned in these
lectures, you should be ready to build on that advantage and defend
it against potential rivals.

Suggested Reading

Bossidy and Charan, Execution.

Burgstone and Murphy Jr., Breakthrough Entrepreneurship.
Ries, The Lean Startup.

Wujec, “Build a Tower, Build a Team.”

Questions to Consider

1. What questions should an entrepreneur consider before launching a
new venture?

2. What advantages does a lean start-up approach have over traditional
business planning for new ventures?

3. Where might entrepreneurs seek assistance as they try to launch a
new venture?

Critical Business Skills:
Operations

Thomas J. Goldsby, Ph.D.

Critical Business Skills: Operations

Scope:

T he world is full of great business ideas—products and service
concepts that hold immense promise for businesses and the customers
they serve. Yet what is the value of a great idea? It amounts to little
if a business cannot execute—that is, produce the product or service in
conformance with customer expectations in such a way that customers feel
great about buying it. In the best case, customers even take pride in their
association with products and services they buy. And that’s the goal of
any company: to develop a band of loyal patrons—or even fans—who not
only buy the products but convince others to buy them, too! You know the
companies that enjoy this kind of following: Amazon, Apple, Costco, Nike,
Southwest Airlines, and Starbucks, among others.

These are some of the companies we’ll examine in this section of the course,
exploring the ways in which these firms take great ideas from concept to
reality by way of operational excellence. Operations is the business activity
that enables companies to keep the promises they make to their customers. It
includes the sourcing of materials and goods, the conversion of those inputs
into something that someone wants to buy, and the delivery of those goods.
Quite simply, it’s how great ideas get turned into great products and services
that a customer can purchase. And operations management is the discipline
of getting the most out of a company’s people, processes, and technologies.

We’ll explore the fundamental aspects of operations that organizations use to
translate good ideas into winning businesses, covering such essential topics
as inventory management, supply management, distribution and logistics,
and performance measurement. We’ll take a close look at how companies
are competing through supply chain management and examine the latest
trends and research on business strategies that enhance agility, resilience,
and sustainability. Among the most strategic of all operations decisions is
the determination of whether to make or buy—to insource or outsource
business activities. This determination is a multifaceted one, subject to the

Scope

organization’s proclivity for control and its appetite for flexibility. We'll
consider how companies can leverage both internal and external resources to
extend their reach in the market and ensure profitability.

In light of today’s hypercompetitive market environment, organizations of
all kinds are seeking to implement processes that create the greatest value
for the business and the customers it serves. Companies are emulating the
success of legendary operations companies, such as Toyota and its famed
production system, in order to maximize value and rid themselves of
activities that waste resources and distract the business from its customers.
We’ll explore how organizations of all kinds can achieve optimal outcomes
through implementation of management methods based on Lean Thinking.
We will also consider the Six Sigma method for continuous improvement,
devised by Motorola in that company’s pursuit of variation reduction in
its operations. These continuous improvement methods can be applied
anywhere that work is performed.

We’ll also explore the latest technological developments that promise to
revolutionize both operations and business itself. Can you imagine having
the ability to pick out a product online, download the blueprint, and have it
manifest before your eyes? That’s the promise of three-dimensional printing,
and companies are putting this technology to work today! General Electric’s
aviation business is producing critical parts for aircraft turbines through this
new-to-the-world additive manufacturing method. Minds in the business
world are racing with the potential of such technologies.

Through these lectures, we’ll see that operations are instrumental as a value
generator and competitive differentiator in every business, ensuring that the
right products and services are available in the right form and quantity at
the right place and time—and at a competitive price. We’ll come to realize
that operations management touches virtually every facet of our everyday
existence and ensures our quality of life. ■

The Power of Superior Operations

Lecture 13

O perations is the business activity that enables companies to keep the
promises they make to customers. It includes sourcing materials
and goods, converting those inputs into products that customers
want to buy, and delivering the products. Operations management is the
discipline of getting the most out of a company’s people, processes, and
technologies. In these lectures, we’ll explore the fundamental aspects of both
these activities. We’ll cover such essential topics as inventory management,
supply management, distribution, and performance measurement. We’ll look
at how companies compete through supply chain management and examine
the latest research on business strategies that enhance agility, resilience, and
sustainability. Finally, we’ll consider how companies can leverage internal
and external resources to survive and thrive.

Vision and Market Strategy

• To understand the role of operations in an organization, we need
to know where it fits into the big picture of business decision
making. Most companies begin with an overall vision that drives all
their functional strategies, including operations. The vision is the
statement of how the company wants to be known and sought in
the marketplace. Functional strategies establish how the company
intends to live up to the promise of its vision.

• The first thing companies typically do after establishing a vision is
to devise a market strategy, consisting of the image to be portrayed
in the market. In turn, operations strategy is usually regarded as a
supporter of the marketing strategy. Depending on how a company
wants to be viewed in the marketplace, it will formulate operations
to support that vision.

• Harvard professor Michael Porter has identified three competitive
market strategies from which a business might choose: low cost,
valued differentiation, and a combination of these two.

Lecture 13: The Power of Superior Operations

o Companies using a low-cost strategy seek to win business by
having products and services that reflect a price advantage.
These products and services are considered of sufficient quality
to warrant consideration but are ultimately chosen because
they represent good value in the eyes of customers.

o With a differentiation strategy, companies seek to distinguish
themselves on merits other than low price. In fact, they try
to garner premium prices in light of the uniqueness of their
products and services. Differentiation is usually preferred over
a low-cost strategy because it tends to result in healthier and
more sustainable margins and yields customers who are less
likely to be swayed by competitors that offer a lower price.

o The third market strategy identified is a combination of the
first two. This approach is rare, though it could be argued that
Southwest Airlines implements it quite well. Southwest offers
low prices on air travel yet performs high on key operational
measures, such as on-time service and customer care.

Some high-end carmakers employ a differentiation strategy, seeking to distance
themselves from competitors based on higher levels of comfort, performance,
and aesthetics.

Operations Strategy

• Once a company chooses one of the three competitive market
strategies, it must then decide how to execute, devising an operations
strategy that supports the vision and market strategy. Again, it’s
important for the operations strategy to match the competitive
market strategy. Buying premium supplies or investing heavily in
operations geared toward unique customer outcomes while trying
to compete on price won’t work, nor will using low-cost, standard-
commodity materials while trying to persuade customers to pay for
a customized experience.

• Another consideration in the selection of operations strategy is the
age of the business. Businesses in their infancy usually start with
a single or a limited number of products and services. The size
and geography of the market is usually small at the outset of the
business, as well. For companies at this stage, a single operations
strategy usually suffices. But once the business grows in size and
complexity, multiple strategies may be used at once, and they may
need to change over time.

• What are the operational differences between a company using a
low-cost strategy and one that competes on differentiated products?
Let’s first consider the low-cost scenario.

o In competitive markets, low cost usually translates into low
prices, and low-cost competitors often find themselves in a
“race to the bottom.” The combination of global competition
and the Internet has sped up this race by providing a greater
array of competing options and transparency on prices for
goods and services in different markets. This makes price
advantages fleeting.

o When competing based on price alone, Charles Darwin’s
theories of population ecology come to mind: Only the strong
and adaptable survive. If you lay down the challenge of price
competitiveness, you essentially try to kill off everyone else
in the market, and you become the target that other low-cost
providers seek to kill.

Lecture 13: The Power of Superior Operations

• As mentioned earlier, one alternative is to pursue a hybrid strategy,
competing on a combination of valued differentiation and low cost.
One factor that allows Southwest Airlines to do this is that the
company doesn’t provide service everywhere in the United States.
Instead, Southwest is selective; cities actually market themselves to
Southwest in hopes of landing its services.

o Southwest also keeps costs in check through strategic
operations. For instance, it uses a single model of aircraft for
all its flights, allowing for standardization in spare parts and
maintenance. Further, no first-class service is offered.

o The picture of differentiation here is not achieved through
fanciful offerings or unique approaches. It comes by way of
limiting the company’s focus and executing well.

Operational Capability: Processes

• Operational capability is the composite of processes, people, and
technology used to execute an operations strategy. Processes define
“what you do.” All work is conducted in processes, and today, we
spend a great deal of time studying processes with techniques offered
by improvement methods, such as Lean Thinking and Six Sigma.

• Lean Thinking is dedicated to mapping and eliminating waste from
processes. Mapping processes enables companies to capture the
steps involved in doing work. Some steps are value added, meaning
that the customer cares about these activities and is willing to pay
for these aspects of the work. Value-added steps usually change
the appearance of a product or its performance in some way that’s
noticeable to the customer. All other steps are considered non-value
added and should be reduced or even eliminated from the process.

• Six Sigma is dedicated to reducing variation in processes. When
variation in inputs or in work performance exists, you can expect
variation in the outputs of the process. Unwelcome variations are
called defects, which are the enemy of consistent quality and lead to
adverse customer experiences.

o In statistics, sigma (X) is the Greek notation for standard
deviation, the mathematical measure of variation. To calculate
the capability for a process in terms of variation, it’s first
necessary to calculate the defects per million opportunities. A
defect opportunity is any action that strays from the accepted
standard for delivery of a perfect product or service.

o This defect calculation then converts into a level of sigma
performance. The more sigmas, the narrower the variation
band for the process, meaning that the process is operating
within very narrow tolerances with less observed variation—
and that’s the goal.

Operational Capability: People

• Obviously, the people component of capability speaks to who
does the work. This so-called soft side of operations is often the
“hard stuff’ to figure out. Humans are complex creatures, and
understanding what might motivate one person, let alone large
groups of people, is extremely difficult.

• One consideration that factors into the critical role of people in
operations is automation, which continues to be on the rise in many
settings. But not all work lends itself to automation. Specifically,
automation struggles with nonstandard tasks or situations. Further,
in some circumstances, customers prefer interacting with another
person, as opposed to a computer screen.

• It seems that at least for the foreseeable future, we will continue to
rely on people to perform many critical tasks. But a fundamental
question that companies must ask when executing an operational
strategy is whether they will do the work themselves ( insourcing )
or whether they will hire others to do the work on their
behalf ( outsourcing ).

Lecture 13: The Power of Superior Operations

Operational Capability: Technology

• The final component of operational capability is technology,
specifically, the assistance received from both equipment and
information technology to enable higher-performing processes.
Technology lends great convenience and enhanced capabilities to
work and everyday life, but it should not drive strategy. Business
strategies that rely first on technology can be too easily duplicated
by competitors—and leapfrogged when a better technology comes
along. Competitive advantage achieved through the other aspects of
capability—processes and people—can be more difficult to copy.

• The idea of technology as an enabler of process refers to the use of
technology to help make sense of complex situations or those laden
with data and information. Decision support tools, such as statistical
software and business analytics, can help with these problems. In
addition, data capture and communicative technologies can help
when a company is unable to “see” a process and its performance.
GPS, for instance, is wonderful technology for illuminating an
otherwise hard-to-see process from afar.

• Finally, any physical equipment that might be used to lighten the
load or speed up the work also represents technology. Companies
should embrace equipment technology when it advances processes
and allows them to avoid sending people into hazardous situations.

• The challenge of operations management is to use operational
strategy to guide the processes, people, and technology that
constitute operational capability to achieve business success. This
isn’t a quick or easy task, and once you think you’ve got it figured
out, it’s probably time to revisit the decisions. All organizations—
from start-ups to multinational corporations—must adapt to stay
relevant to customers, and adapting the company’s operations is a
critical part of that process.

Suggested Reading

Browning and Sanders, “Can Innovation Be Lean?”

Davenport, Mule, and Lucker. “Know What Your Customers Want Before
They Do.”

Schroeder, Goldstein, and Rungtusanatham, Operations Management in the
Supply Chain.

Simchi-Levi, Operations Rules.

Questions to Consider

1. Why is it important to link a company’s operations strategy to the
overall business strategy?

2. How can an operations strategy provide identity for a company?

3. Can you think of examples of companies that win in the marketplace
through distinctive operations strategies or well-executed operations?

Lecture 14: Leaner, Meaner Production

Leaner, Meaner Production

Lecture 14

A s we saw in the last lecture, operations is the business activity that
fulfills the promises that companies make to their customers. It
includes sourcing materials and goods, converting those inputs into
something that customers want to buy, and delivering the goods. Production
operations are those that involve the provision of actual goods as opposed
to services. Production operations for physical goods are also referred to as
manufacturing operations and have the primary function of converting inputs
into desired outputs for customers. They represent the greatest value-adding
activity in all of business, transforming the useless into the useful.

The “Make -vs.-Buy” Decision

• One of the most fundamental decisions that any company interested
in selling products must make is whether to produce the product
in-house or to hire an outside company to manufacture the product
on its behalf. This determination of insourcing versus outsourcing
is often called the “make-vs.-buy” decision. Both options are
considered part of production operations, but they involve different
organizational arrangements.

• In making this decision, the place to start is with simple economics:
determining what it would cost your company to produce the
product—taking into account fixed capital costs and the costs of
running the operation—versus what a contract manufacturer would
charge for its services.

o Complicating this analysis is the expectation of future sales.
If the product is a big hit, you could cover your fixed-cost
investments with the increasing sales volume, but you might
also have to expand operations in a hurry.

o Another complication can arise when customers ask for
different items or unique packaging. Just as we consumers seek
unique, differentiated products, so, too, do business customers.

Large retailers and distributors want to be able to offer product
assortments that can’t be found anywhere else. That can create
a problem if you sell to and through many different retailers.

• Contract manufacturers excel at making adaptations because
manufacturing is their core competency. They tend to have skills in
developing proper tooling and quick changeovers from one product
to another. They can also offer economic advantages because the
production facility is shared with multiple clients, and costs are
spread across these clients.

• For these reasons, many young companies that are bringing products
to market for the first time choose outsourcing over insourcing.
They can get into business without having to build a factory and
invest in manufacturing equipment and a trained workforce.

• However, there are also disadvantages to outsourcing, the most
significant of which is control. You take the risk that the contract
manufacturer won’t have your best interests at heart when
producing your goods. There’s even the risk that a company that
learns how to make your product could steal it.

It's estimated that the global market for contract manufacturing in electronics is
more than $450 billion.

gerenme/iStock/Thinkstock.

Lecture 14: Leaner, Meaner Production

• For that reason, you need to analyze the transaction costs associated
with hiring an outside party. Transaction cost analysis (TCA) is a
distinct branch of economics that examines the costs of monitoring
another party to act on your behalf.

Outsourcing Considerations

• Companies that outsource often opt for suppliers in countries
where wages for labor are lower than in developed economies—a
practice known as offshoring. However, some companies have later
retracted this decision when they find that they’ve underestimated
the transaction costs and the amount of oversight required
with offshore manufacturing. This is particularly true when
manufacturing problems make product recalls necessary.

• Another circumstance that would warrant reconsideration of
outsourcing is the discovery of labor abuses at contract manufacturing
locations. Public pressures and, increasingly, government regulations
are forcing companies to be more transparent about who they hire,
where suppliers are located, and the standards in place to ensure that
work practices are consistent with Western norms.

• If you still elect to hire an outside manufacturer—despite these
cautions—work with an attorney who is seasoned in negotiating
such deals. This is especially important when doing business across
national boundaries.

Manufacturing Strategies

• If you decide that you’re better off making your product yourself,
you first need to decide what manufacturing strategy you will use.
There are five primary strategies to consider.

• The first strategy is called ship-to-stock, or a full anticipatory
strategy. Under this strategy, companies put complete faith in
their sales forecasts, using those numbers to drive purchasing,
production, and distribution. In other words, a company builds
and distributes products in advance of demand and hopes that it
has estimated correctly.

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o Companies use this strategy in situations where customers
expect to find the product on the shelf, buy it, and make use
of it immediately. Thus, this strategy is used for virtually
everything sold in, for example, grocery stores.

o Of course, with this strategy, when you underestimate demand,
you are left with disappointed customers. And when you
overestimate demand, you’re left with extra inventory that you
may need to mark down or even write off.

• One step away from ship-to-stock is the make-to-stock strategy.
In this case, companies buy materials in advance and manufacture
products in accordance with sales forecasts, but they do not allocate
the goods to distribution locations until they receive customer
orders and know exactly where to ship.

o This delaying of the delivery step allows companies to hold
inventory centrally for all distribution locations and, thus, get
by with lower inventories.

o But holding inventory centrally and postponing delivery until
orders are in hand means that customers have to wait for delivery.

• The next strategy is called assemble-to-order, configure-to-order,
or mass customization. With this strategy, materials are procured in
advance of demand and products are made only to a semi-finished
state. The finished product doesn’t take shape until the company
learns exactly what the customer wants. This strategy is ideal for
basic products that can be sold with small differences.

o This strategy allows a pool of common inventory to cover the
needs of customers who are looking for something slightly
different, again, reducing inventory requirements but requiring
additional time to perform the final touches on the goods and
deliver them.

o Toyota provides an excellent example of mass customization
with its Scion brand of cars. The cars are manufactured to a
generic state in Japan but held in large supplies by major

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Lecture 14: Leaner, Meaner Production

U.S. distributors. Customers select options from the company
website, and when an order is confirmed, the closest distributor
alters the base model according to the customer’s requests.

o Through this assemble-to-order strategy, Toyota is able to
provide customers with seemingly limitless choices yet with
much less inventory than if the company pre-built cars to cater
to customer demands. However, under this system, customers
have to wait a few days or a few weeks to take possession of
their cars.

• The fourth manufacturing strategy is the make-to-order strategy.
In this scenario, the manufacturer has the raw materials on hand
but does not commit to assembling them until receiving a customer
order, in delaying the assembly process, the manufacturer has even
more flexibility to accommodate diverse customer preferences
related to product form and function. Such a strategy might be used
for a highly customized luxury vehicle.

• The fifth strategy is the least speculative of all for the producer:
the buy-to-order strategy. Here, the producer awaits the customer
order before even purchasing the raw materials. This allows for
products to be truly custom-built, but customers must expect longer
wait times under this system. Such arrangements are sometimes
used in the provision of large industrial products, such as aircraft or
satellites, or in homebuilding.

• Large manufacturers often use multiple strategies to accommodate
their varieties of products. Smaller companies generally start off
with one of the less risky and less speculative strategies, such as
buy-to-order or make-to-order, so that they can conserve cash for
investments other than inventory.

• Lean Thinking has had a significant influence on the management
of inventory as it relates to production strategies.

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Traditionally, companies relied on inventory to deal with a
variety of problems. For example, the problem of inaccurate
sales forecasts or unreliable suppliers can be solved just by
having more than enough inventory to cover any shortfalls or
late shipments.

o Lean Thinking, however, encourages companies not to rely on
inventory. Instead, companies should improve their forecasts
or design flexible operations that make them less dependent on
forecasts and more responsive to actual demand. Companies
are also encouraged to work only with reliable suppliers or to
help existing suppliers deliver better materials more reliably.

Developments in Production Operations

• Advanced technologies are making significant changes in the
world of production operations. In fact, one major development
is threatening the entire system of factory-based mass production
that we have known over the past century. This revolution is the
advent of three-dimensional printing, creating what’s known as
form-on-the-spot.

o This technology has found use in the production of models and
prototypes in recent years, but the prospects for using form-
on-the-spot production have set minds racing in the operations
field. Just as we now download music and books from the
Internet, imagine downloading three-dimensional blueprints,
hitting the print button, and watching physical goods take
shape right before your eyes!

o To date, three-dimensional printing is limited to simple
products with simple materials. That situation is changing
quickly though; such companies as General Electric are
making significant investments in advancing the manufacturing
capabilities of the printing equipment.

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Lecture 14: Leaner, Meaner Production

• Another development to watch is the rise of nearshoring and
reshoring. Although some companies continue to favor outsourcing
of manufacturing operations to suppliers in low-cost countries,
there is also a trend in the opposite direction.

o Companies have learned that it’s difficult to anticipate all the
things that can go wrong with offshoring, such as frequent
power outages, high labor turnover, and so on. In reaction to
this reality, many companies that once offshored to low-cost
countries are regionalizing their supply chains, meaning that
they are seeking to produce closer to the markets they’re trying
to serve.

o Nearshoring refers to the practice of producing close to the
focal market, probably in a location that still offers some cost
advantage but with less uncertainty than far-off locations.
Reshoring refers to bringing once-offshored manufacturing
back home.

• Finally, the next significant wave of innovation in production
operations may come with the focus on sustainability. Our ability
to serve a growing population in a more sustainable fashion will
be at the forefront of corporate decisions and national policy in
the coming years. This could mean choosing different materials
and creating products using manufacturing processes and energy
sources that don’t pollute the air, land, or water.

• Production operations is a key factor in all these developments.
Whether it drives them or simply incorporates and adapts to them,
it will be central in the years ahead to some of the most dramatic
changes in how we live, how we create, and how we interact with
our planet.

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Suggested Reading

Kazmer, “Manufacturing Outsourcing, Onshoring, and Global Equilibrium.”

Shih, “What It Takes to Reshore Manufacturing Successfully.”

Simchi-Levi, Peruvankal, Mulani, Read, and Ferreira, “Is It Time to Rethink
Your Manufacturing Strategy?”

Williamson, “Outsourcing.”

Questions to Consider

1. Why would a company elect to outsource the production of products
bearing the company’s brand name? What are the risks inherent
in outsourcing?

2. How do you select the right manufacturing strategy for a product? What
makes it the “right strategy”?

3. How does the pursuit of sustainability affect decision making in
production operations?

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Lecture 15: Refining Service Operations

Refining Service Operations

Lecture 15

O ver the past several decades, the United States has seen a major
shift in its economy—from being dominated by manufacturing to
focusing more on services. This shift is reflected in the fact that
today’s services sector represents nearly 70% of the nation’s gross domestic
product, in addition, six out of seven people in the workforce are employed
in services. In this lecture, we will examine the essentials of managing
successful service operations, taking into account the complex psychology
involved in winning over customers through great experiences. As we’ll see,
there are significant differences between service operations and product-
oriented operations, yet service operations can still borrow some important
concepts from the science of the production world.

Defining Services

• The term services refers to a wide variety of activities, from
consumer services, such as health care, restaurants, retail, and
banking; to industrial and professional services, such as advertising,
transportation, and legal services; to government and civil services,
including schools, emergency services, and postal delivery.

• Perhaps the most fundamental difference between production
operations and service operations is the intangibility of services as
a deliverable.

o Although service operations may sometimes have some of the
attributes of physical products, the deliverable in services is an
outcome or experience for the customer.

o In some ways, this can make the management of services more
complicated and challenging than making a physical product,
where the specifications and requirements tend to be more
concrete.

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Assessing Services

• One of the most significant developments in modem service
operations has been the establishment of the service quality
scale (SERVQUAL). Devised by academics, SERVQUAL is a
measurement system dedicated to assessing customer satisfaction
with services. It has revolutionized how we think about and assess
service delivery.

• SERVQUAL’s basic premise for discerning customer satisfaction
is simple: It compares the customer’s perception of the service as
it was actually rendered against the expectations the customer had
going into the service arrangement. If the perceived performance
exceeds expectations, then the customer is satisfied. If expectations
are not met, the customer is said to be dissatisfied.

• SERVQUAL assesses service quality by comparing expectations
and perceptions of performance across five important dimensions.
These dimensions, listed below, form the acronym RATER.

o Responsiveness: how promptly the service provider responds
to the needs of the customer.

o Assurance: the level of the customer’s ease that the service will
be conducted in accordance with his or her wishes.

o Tangibles: the physical aspects of the service provision,
including the facilities, equipment, and personnel that will
shape the customer’s experience.

o Empathy: the sense of caring and understanding extended by
the service provider to the customer.

o Reliability: the ability to perform the service on a dependable
and accurate basis compared to what is promised.

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Lecture 15: Refining Service Operations

Arguably, building relationships is of much greater importance in service
industries than in production businesses because service comes down to
trust—trusting that the outcome will be what the customer is seeking.

• In addition to providing a scale of service quality, SERVQUAL also
identifies several service gaps that can irritate or repel customers.
These include an inability to match performance with expectations,
differences in expectations between the provider and the customer,
and the perception of performance.

Process Improvement: Lean Thinking

• Because effective service is so important to meeting customer
demands, a field of study known as process improvement has
developed for refining service operations. This discipline comes
from production operations.

• All work—whether it’s manufacturing widgets or making
espressos—is completed in processes, and each process involves
a series of steps in which inputs are converted into outputs
for a customer. The two most influential methods for process
improvement are already familiar to us from the production
operations context: Lean Thinking and Six Sigma. The premise

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monkeybusinessimages/iStock/Thinkstock.

of both these methods is that all processes can be improved. This
reasoning is particularly true in services because they rely on
people, who are prone to errors.

• One principle of process improvement that can help achieve high-
performing services is the concept of standard work. This involves
finding the best way to complete a work task, documenting it, and
teaching it to others. This is a simple idea, but it’s hard to achieve
in service environments, where operators tend to develop individual
patterns of behavior. And when no standards exist for work, you can
expect different qualities in the outcome. The challenge for services
is to provide consistently good outcomes for customers.

o In 2009, Starbucks set out to address this problem by setting
up its Lean Innovation Lab. The goal was to develop and test
different ways to perform store routines in search of the best
way to perform all varieties of work, including cleaning up,
restocking displays, and preparing coffee.

o The initiative had numerous benefits. By finding and
standardizing its best practices, Starbucks ensured a cleaner
and more appealing sitting area and reduced the amount of time
and wasted motion involved in brewing and serving coffee.
Creating standard work routines resulted in achieving positive
customer experiences more consistently, which has fueled top¬
line growth and reduced costs.

• Another valuable way to apply lean principles in service settings is
to compare process time with takt time. Takt is a German term that
refers to the targeted or goal time for an activity—the amount of
time in which an activity must be completed in order to keep pace
with demand. In contrast, process time refers to the amount of time
required to actually complete the activity.

o Consider, for example, a men’s grooming salon. The owner of
the salon would like to achieve as much throughput as possible
in the shop. Many of the costs associated with the shop are
fixed; thus, the more customers served, the more revenue and
profit can be achieved.

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Lecture 15: Refining Service Operations

Let’s say that on average, it takes 20 minutes for a stylist to
give a simple haircut. This is the process time for the work.
Over the course of an 8-hour day, a stylist could serve 24
customers, or 3 per hour. But what if the shop has demand for
80 haircuts a day? Clearly, that demand cannot be met with one
stylist because it translates to 26 % hours of work.

o The takt time to keep pace with this demand is determined by
dividing 8 hours (480 minutes) by 80 customers; the result
is 6 minutes. But the process time is more than three times
that! Clearly, the owner will need more resources to serve 80
customers in 8 hours.

o This comparison of process time and takt time can be helpful in
determining the amount of resources needed to get a job done
in an allotted amount of time. But the real lesson here is not to
simply take these numbers as a given. By finding the best way
to perform the work, companies can reduce the process time
required to serve their customers, making them better able to
meet greater demand.

• Another variable that companies sometimes overlook when
managing the supply-demand equation is their ability to alter
demand through pricing. That’s not a service operations decision
per se, but it can have a significant impact on the provision of
services. For example, Dell has long used a “sell-what-you-have”
strategy that drives customers to the products the company has
high in inventory and away from items that are at risk of going into
backorder. This is accomplished by simply changing the price for
these items in a dynamic manner.

• Related to the pace of demand, something that anyone working in
services knows is that if you have to staff a business at all times
to handle unexpected peaks in demand, you’ll have significant
downtime. To address this problem, Lean Thinking sets forth the
concept of heijunka, a Japanese term that refers to the smoothing

out of demand. Such smoothing out can be accomplished by
offering discounts or other promotions to drive business to off-peak
times and avoid the problem of paying staff to sit idle.

Process Improvement: Six Sigma

• The Six Sigma approach can also be applied to service environments.
As mentioned earlier, the term relates to the standard deviation in a
process. Standard deviation is a measure of variation. When there is
variation in inputs or variation in how work is performed, the result
will be variation in outcomes.

• Six Sigma encourages businesses to root out the sources of variation
and establish greater precision in how work is conducted. This
approach refuses to accept the idea that to “err is human” and seeks
to eliminate the sources of error—not the people but the actions
they perform that lead to error and defects.

• By definition, Six-Sigma performance is achieved when defects
number fewer than 3.4 per 1 million opportunities for defect.
Achieving that level of defect-free performance is probably not
attainable in human-driven processes, such as those found in most
services. But whether an organization achieves 6 sigma, 4 sigma,
or 2.5 sigma is not what really matters. What matters is whether
the company and its processes are improving. And if the firm is
improving faster than its competition, that bodes well for the future.

Service-Dominant Logic (SDL)

• One business theory that has drawn a good deal of attention recently
is service-dominant logic (SDL), which to some degree unites the
principles of service operations and production operations. SDL
suggests that businesses move away from marketing goods to a
notion of co-creation of value. The idea is that in a purchase situation,
customers are buying more than just a product; they’re buying the
ability to use the product in the pursuit of enjoyment. There is an
ongoing relationship between the customer and the product, and that
creates new business opportunities for the provider.

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Lecture 15: Refining Service Operations

• This is a fundamentally different way to view a product and, in
turn, to sell the product. It is not an end in its own right but part
of a solution. We see similar transitions to a solution orientation
occurring in many industries. Xerox, for example, has moved away
from selling copiers to business customers. Instead, it installs a
multifunction copier in an office, and the customer is charged for
its use based on pages copied and documents scanned, printed, and
mailed. This shift in orientation has turned what might have been
one-time sales into lucrative, ongoing revenue streams.

• Notice that there is a physical product at the center of the services
that Xerox provides. The new focus, however, is on a creative
solution that doesn’t involve dumping the product in the lap of the
customer, then walking away. Rather, it involves establishing and
maintaining a relationship with the customer. It becomes much
more difficult for competitors to sway customers with grandiose
promises when customers trust your company to deliver desired
outcomes reliably.

Suggested Reading

George and George, Lean Six Sigma for Service.

Hsieh, “Zappos’s CEO on Going to Extremes for Customers.”

Kastalli, Van Looy, and Neely, “Steering Manufacturing Firms towards
Service Business Model Innovation.”

Ramdas, Teisberg, and Tucker, “Four Ways to Reinvent Service Delivery.”
Rawson, Duncan, and Jones, “The Truth about Customer Experience.”
Zeithaml, Parasuraman, and Berry, Delivering Quality> Service.

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Questions to Consider

1. What makes the provision of services different from production
operations? Is it easier in some ways and harder in others?

2. Name a service company that you would consider great. What makes
this company great?

3. How do the principles of operational excellence found in Lean Thinking
and Six Sigma help a service business to compete more effectively?

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Lecture 16: Matching Supply and Demand

Matching Supply and Demand

Lecture 16

S ales and operations planning (S&OP) is a proven method for finding
the balance between promise making and promise keeping. The
process consists of the integration of a company’s sales forecasts
with the operations plans from the purchasing, production, and logistics
departments. In this lecture, we’ll examine the specific inputs and
organizational requirements needed to achieve this balance.

Background on Sales and Operations Planning (S&OP)

• Most businesses are composed of different departments, such as
sales, marketing, accounting, purchasing, production, logistics,
R&D, and HR. The reason for this is that humans deal with
complexity by becoming specialized, developing knowledge and
skill sets that allow us to perform specific functions.

• A functional orientation helps us ensure that we “cover all the bases”
in an organization, but it’s sometimes difficult to establish balance
and coordination across the departments. This is particularly true
when the departments are in conflict with one another. There is a
natural tendency in times of conflict to defend our turf, rather than
to give in and pursue outcomes that might benefit the collective
good. Further, companies often have measurement systems in place
that reinforce “functional silos” and turf wars.

• Perhaps the greatest divide found in organizations is the one
between the demand and supply sides of the business. The
customer-facing departments responsible for generating demand—
namely, sales and marketing—are held accountable for top-line
revenue. Meanwhile, the supply-side operations departments, such
as purchasing, production, and logistics, have the responsibility of
delivering on that demand but doing so at the lowest possible cost
to ensure that the company nets margins and profits.

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• These two forces often find themselves at odds. The promise
makers in sales and marketing blame operations for an inability
to satisfy the demand they’ve worked to create. At the same time,
the operations personnel take offense at what they see as sales and
marketing’s casual approach to making promises that probably
shouldn’t have been made in the first place.

• It’s important to get promise makers and promise keepers on the same
page because failing to deliver on customer orders or being forced to
temper demand affects the company’s credibility in the marketplace
and creates opportunities for competitors. Undersupply opens the
door for the competition, and oversupply leaves excess inventory
that must either be marked down or written off. Sales and operations
planning (S&OP) was designed to address these problems.

• Fundamentally, S&OP is about gathering and sharing information.
Thus, the first step is to form an S&OP team of senior departmental
representatives from within your company and gain the buy-in of
the parties involved. As the term S&OP suggests, the key function
of this team is planning.

The goal of the monthly S&OP team meeting is for all parties to arrive at
a common vision of what’s expected in the coming month and to share a
commitment to doing their part to fulfill that vision.

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Lecture 16: Matching Supply and Demand

o The sales and marketing representatives should work together
to bring forward the sales picture for the coming months.

o The purchasing, production, and logistics reps prepare capacity
plans, with ready explanations for any anticipated changes in
operating capacity.

o Finance and HR play consultative roles related to the
deployment of financial and human resources.

o New product development speaks to the readiness and timing
of product launches that can be expected to siphon resources
from existing products.

Sales Forecasting

• Considerable work takes place within each department leading up
to the monthly meeting of the S&OP team. Sales and marketing
should collaborate to coordinate promotions and other strategies
that might be in place to bolster sales. These team members also
generate short-term sales forecasts, typically covering a period of
one to three months. Sales forecasts come in one of two varieties:
qualitative or quantitative.

• Qualitative forecasts are essentially best guesses—forecasts made
without necessary data; however, these forecasts are not shots
in the dark. They rely on the opinions of experts who are closest
to the market—field sales representatives and headquarters
marketing managers. These experts base their judgments on
market intelligence, including trends for sales of related items,
demographic changes, and responses to market inquiries and field
testing of products or services. In the absence of sales history—as
with completely new products—qualitative estimates are often the
best options available.

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• Quantitative forecasting methods come in many different forms.
Ideally, they rely on data from past sales of the same item. In the
absence of this information, they might use historical sales of
similar or complementary items.

o The easiest but least infonned quantitative forecast is a simple
average. Here, a company divides the average sales over an
entire year by 12 months and makes its plans with the expectation
of selling approximately the same volume each month.

o The moving average technique looks at recent history only—
perhaps the last 3 months—to gauge the anticipated sales for
the month ahead.

o Exponential smoothing looks at the previous month’s sales
forecast and the actual sales from that same month. An alpha
value, or smoothing factor, is then applied that governs how
much emphasis is placed on each factor. The sum of actual
sales multiplied by alpha and forecasted sales multiplied by -1
alpha yields the forecasted value for the coming month. This
approach is intended to take some of the emotion out of the
forecast while still relying on recent data.

o The regression analysis method offers a predictive model that
allows many factors to be considered at once, including the
unique influence of trends, seasons, and cyclical influences.
This method is used for products that have been in existence
for some time and for which extensive sales data are available.

• Most companies use a combination of quantitative and qualitative
forecasting methods. The ideal approach is to generate a quantitative
forecast as a baseline, then have experts weigh in on those numbers.
Were there unusual occurrences in recent months that affected the
historical data? Are there any expected occurrences in the near
future that could affect the forecast? Blending historical data with
expert opinion brings together the best of both worlds.

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Lecture 16: Matching Supply and Demand

Capacity Planning

• The other side of the S&OP equation is capacity planning,
specifically, planning for supply, production, and the combination
of logistics and distribution. Limits in any of these can impair the
company’s ability to accommodate the expected demand found in
the sales forecast.

• Supply capacity probably rests beyond the direct control of your
firm. It’s dependent on the capacity of your suppliers and your
ability to extract supplies from them. Typically, companies have
some suppliers that seem to be able to offer limitless supplies and
others that present constraints. The constraints may be absolute,
meaning that there are limits to these suppliers’ ability to serve you,
or the added volume may simply come at a price. Companies need
to understand both of these because they can influence the volume
and price of supplies that can be acquired.

• Supply and production capacity come together in the materials
requirements plan (MRP), which expresses the quantity and timing
of supplies required to feed production. The MRP is usually driven
by the production forecast, or the master production schedule
(MPS). This schedule illustrates what the company expects to
produce over a period of time, often a month, and can be broken
down into weekly or even daily plans for production. Clearly, the
sales forecast should influence this production forecast.

• The third capacity plan necessary for S&OP is one for logistics
and distribution. Here, there may be capacity constraints on how
much product can be stored and moved over a period of time. That
capacity may be limited by warehouse space available, the size
of storerooms, or the number of transportation vehicles available.
Your company may own these capacities, or it may hire outside
companies to provide the required space and transport.

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Flexibility in S&OP

• With the compilation of the sales forecast and capacity plans for
supply, production, and logistics and distribution, you have what
you need to make decisions at the S&OP planning meeting. The
goal of the meeting is to come up with a single set of numbers that
everyone will work toward in the coming period.

• However, the S&OP process doesn’t end with agreement on a
common set of numbers. Once the month begins and sales start to
trickle in, everyone needs to communicate about potential problems
with the forecast. The same is true for operations plans. Countless
forces could be at work, threatening to alter your best-laid plans for
meeting demand.

• The often-forgotten component of S&OP is flexibility, which must
be built into operations to accommodate the unexpected. The
more flexible your operations, the more variation your system can
accommodate and the less likely your customers are to experience
any negative consequence as a result of fallible planning. Should
you not be able to accommodate customer needs, you must devise
priorities to detemiine which customers to serve with your limited
supplies.

Integrated S&OP

• These same principles for managing supply and demand within a
company can also be applied across companies in the supply chain,
meaning the entire system of inputs, outputs, and distribution.
That is, companies can collaborate with suppliers and customers to
realize a common vision of the business they will conduct together.

• To understand this idea, imagine a see-saw. On one end is a large
box labeled Demand. On the other end are two smaller boxes
labeled Capacity and Inventory. Positioned in the middle of the see¬
saw is the fulcrum on which it rests, labeled Plan.

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Lecture 16: Matching Supply and Demand

The see-saw analogy captures the benefits of integrated business
planning; in the event of increases in Demand, moving the Plan closer to
the Demand side allows companies to get more leverage from existing
Capacity and Inventory.

• The see-saw is in balance when the weight of the Capacity and
Inventory together counter the weight of Demand. If Demand
were to grow, more weight would be needed in Capacity and/
or Inventory to bring the see-saw back into balance. Yet there is
another possibility—the fulcrum. What if you were to move the
Plan closer to the Demand side of the see-saw? With that action,
you get increased leverage from existing Capacity and Inventory.

• The lesson here is that if you can plan closer to demand—that is,
forecast demand more accurately—then you need less capacity and
inventory to fulfill demand. The answer is sharing information and
collaborating within companies to find the balance between demand
and supply.

• Now, imagine lining up multiple see-saws side by side and
working with people at each one to find the right balance for
each of the see-saws in tandem. That would represent the notion
of integrated business planning across companies in the supply
chain. No doubt, it’s a challenge, but it’s one that yields significant
benefits for the players.

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Suggested Reading

Box, Jenkins, and Reinsel, Time Series Analysis.

Kahn, “Solving the Problems of New Product Forecasting.”
Muzumdar and Fontanella, “The Secrets to S&OP Success.”
Stahl and Wallace, “S&OP Principles.”

Wallace and Stahl, Sales and Operations Planning.

Questions to Consider

1. Flow does the struggle between promise making and promise keeping
shortchange or challenge the performance of a company? Why is it
important to keep these two in balance?

2 . We know that forecasts will not be perfectly accurate. What are the
implications of this fact for our capacity plans? Is it wise to build in
extra capacity to deal with peak demand?

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Lecture 17: Rightsizing Inventory

Rightsizing Inventory

Lecture 17

I nventory can be among the most valuable assets for a company—and
it certainly seems that way when you don’t have enough to feed your
business or serve your customers! But having too much inventory can
be a bad thing, too. Even if it’s just in storage, inventory can consume many
resources in your business—resources that could be put to more productive
use elsewhere. In this lecture, we’ll explore the fundamentals of rightsizing
inventory through inventory management. The primary goal of inventory
management is to determine what to inventory and in what quantities to
maintain just the right amount of inventory—no more and no less!

Inventory Management Metrics

• Companies hold inventory in the hopes of generating more sales
and in fear of facing a stockout —a lack of inventory—resulting in
the inability to serve customers. But holding inventory is expensive.
The financial impact of holding inventory is measured in the form
of inventory carrying costs, or holding costs. The more inventory a
business holds, the higher these carrying costs are.

• The primary component of inventory carrying cost is the opportunity
cost of capital, that is, the cost of having money tied up in inventory
that could be put to use elsewhere in the business, perhaps in new
technology or staff training. In addition to the opportunity cost
of capital, the inventory carrying cost calculation also includes
insurance and taxes associated with holding inventory. And there
are risks to holding inventory, including the risks of the inventory
becoming damaged, stolen, obsolete, spoiled, or out of date.

• Aside from inventory carrying cost, a key metric of inventory
management performance is inventory turns. This measure can be
calculated on an item-by-item basis or across a company for all its
items. The aggregate calculation provides an overall measure of
inventory efficiency. It’s calculated by dividing the cost of goods

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sold by the dollar value of average inventory. A company that can
generate more sales on lower inventory has a higher number of
turns, suggesting a more efficient operation,
o The item-specific measure of inventory turns provides a
good read on the company’s efficiency with respect to an
individual item.

o For instance, an item that generates 20 turns a year compared
to another that generates only 5 is four times as efficient from
an inventory standpoint. The 20-turn item might be labeled a
“fast mover,” and the 5-turn item might be a “slow mover.”
Fast- and slow-moving items can be managed differently in
light of the different burdens they impose on the business.

• Increasingly, companies are using inventory turnover not only
as a means of self-evaluation but also as a way to evaluate their
suppliers. Many large retailers, for instance, use a measure known
as gross margin return on inventory (GMROI) to evaluate the
attractiveness of a supplier’s goods. This is a hybrid measure that
combines gross margin and inventory turns in a single metric.

o Let’s say that an item enjoys a 20% margin for the retail store
but turns only three times per year. The GMROI would be
0.2 x 3 = 0.6. Some sources claim that an item must achieve a
3.2 GMROI to break even, but that’s a broad guideline.

o GMROI offers a good way to compare different items within a
product category and can help retailers decide which items to
stock and where to stock them.

Product Proliferation

• Product proliferation, or the growth in the number of items a
company stocks, is among the greatest challenges facing businesses
today. Companies are eager to introduce new items, believing that
doing so drives sales growth, and that’s often true. But companies
are also reluctant to eliminate items. The result is an ever-growing
assortment of items that add cost and complexity.

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Lecture 17: Rightsizing Inventory

• Small businesses are especially prone to this problem. When a
business is small and trying to grow, it wants to promise the world
to its customers, but the weight of inventory to fulfill that promise
is simply too heavy. Believe it or not, poor cash flow resulting from
holding too much inventory can be blamed for more failures among
small businesses than almost any other culprit.

• Having only one or a few brands within a product category is the
driving strategy of such grocery retailers as Save a Lot, ALDI, and
Trader Joe’s. By carrying only one item in most product categories,
these stores manage their inventory much more efficiently and, in
turn, offer more competitive prices for their products.

Inventory Management Strategies

• There are four basic inventory management strategies. These
strategies can be distinguished based on how a business interacts
with its suppliers in choosing how much and how often to order.

With today’s inventory-tracking technologies, many companies monitor
inventory at all times and manage accordingly.

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• The simplest option is a fixed quantity-fixed frequency strategy.
With this strategy, a business orders the same quantity every
time an item needs to be replenished, and the order is placed on a
scheduled basis.

• The next strategy is the periodic review method, or P-system,
where P stands for a fixed period of review. This strategy is also
sometimes referred to as a min-max approach.

o Once an inventory count is taken (perhaps every 10 days) and
it’s realized that a reorder point has passed, managers order up
to a maximum level for that item—a predetermined quantity
that the company is willing to hold. The periodic method of
inventory management is variable in terms of quantity ordered
but fixed in terms of timing.

o Companies using this method establish reorder points that
are a little higher than those used by companies that monitor
inventory constantly. As a result, under the P-system,
companies tend to carry a little more inventory. They also
run the risk, however, of incurring prolonged stockouts when
they’re not on top of runs on inventory.

• Of the other two as-needed inventory strategies, one involves
ordering in fixed quantities and the other allows for variable
quantities. Using the fixed-quantity strategy, known as a Q-system,
a company might order as needed in minimum order quantities
imposed by the supplier, or the company might determine the
quantities needed for itself. One common fixed-quantity approach
is known as the economic order quantity (EOQ). This approach
balances the annual cost of holding inventory and the annual
administrative cost of processing orders.

• Ordering in fixed quantities, though, does not take advantage of
the flexibility that companies seek today. That’s why many have
advanced to the fourth strategy, where neither the order quantity nor
the timing of orders is fixed. This is a just-in-time (JIT) strategy.

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Lecture 17: Rightsizing Inventory

o Rather than counting on large lots and infrequent ordering,
JIT companies resort to small order sizes and high frequency.
When demand is brisk, they increase either the batch size or
the frequency, depending on costs. However, the focus is on
keeping inventories low and replenishing only what’s depleted
when it’s depleted.

o Companies often employ a kanban (“signboard”) system to
signal demand and the need for replenishment. The electronic
versions of these systems are known as e-kanbans.

Choosing the Best Strategy

• As noted previously, most companies don’t manage a single product
but several different ones. The largest companies might have
more than a million items to track and manage, and even a simple
business can have an inventory of several hundred items. Clearly,
this adds to the complexity of managing inventory and, often, the
need to implement multiple inventory strategies.

• To address this complexity, most companies use some form of
grouping for their inventory, such as an ABC classification scheme,
o Under such a scheme, A items are those that sell in high

volume, earn high margins, or are sold to the company’s best
customers; new products might also be labeled A items. These
items are the ones for which the company tries to ensure ready
availability. The company may be willing to take on a greater
supply of A items to be certain that they’re available; a stockout
on these items could be detrimental to the company.

o B items are of a somewhat lower priority and generally
require a closer look to determine exactly how to manage
them. If they’re relatively new, “on the rise,” or not expensive
from a holding-cost standpoint, then a company might be
willing to take on a greater supply. However, if these items
are fading in popularity, easily substituted, or ordered by less
important customers, then having a lower supply in inventory
would be optimal.

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o Finally, C items are those that are on their way out. They
may be unprofitable items, costly to keep, or on their way to
becoming dead stock.

• Clearly, companies can create more complex classification schemes
by simply adding letters to provide greater granularity. Also, a
multi-letter scheme might be used to capture different dimensions.
For example, a CBC item might be slow moving, marginally
profitable, and sold to less valuable customers than a triple-A item.

Innovations in Inventory Management

• In light of the intense focus on inventory management in recent
years, innovations present themselves frequently. One such
innovation is the use of radio frequency identification (RFID)
to track inventory as it flows through the supply chain. RFID
technology comes in two basic types.

o Active RFID involves attaching a small device to each product.
The device has its own power source and emits a signal to
indicate its location, enabling the product to be tracked. This
technology is used in the transport of very large items, such as
military armaments and shipping containers.

o With passive RFID, the RFID tag can hold much more data
than the traditional barcode, providing a unique identifier for
that specific item and unit. With the added memory capacity,
companies can track not only the unique identifier for that unit
but also the production date, lot number, and special data, such
as whether the good is hazardous or recyclable.

o Electronic readers positioned at the inbound and outbound
doors of facilities send energy to the passive RFID tag. This
energy activates the tag, which sends a signal back to the reader
with all of the data encoded in the tag. Because the whole
process is automated, hundreds of items can be read at once.
This compares favorably to traditional barcodes, which can be
read only one at a time and often rely on people with handheld
scanners to correctly scan each unit in and out of inventory.

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Lecture 17: Rightsizing Inventory

• Another technological innovation that could affect inventory
management dramatically is three-dimensional printing. Being
able to create form-on-the-spot has tremendous implications for
what companies stock in inventory and where they stock it. Among
the more exciting developments is the prospective use of this
technology in the production of on-demand medical devices and
artificial body parts. Three-dimensional printing could alter our
businesses, create new opportunities, and change the way we think
about inventory.

Suggested Reading

Callioni, de Montgros, Slagmulder, Van Wassenhove, and Wright,
“Inventory-Driven Costs.”

Gmen and Corsten, “Stock-Outs Cause Walkouts.”

Shepard, RFID.

Spear and Bowen, “Decoding the DNA of the Toyota Production System.”
Waller and Esper, The Definitive Guide to Inventory Management.

Questions to Consider

1. What influences whether the holding of inventory is a blessing or
a curse?

2. What are the problems raised by a stockout?

3. How do you rightsize inventory—that is, determine the right amount
of inventory to hold? Is the rightsized inventory a moving target? Are
there times and circumstances when you might be willing to hold
more inventory?

4. Why do companies try to lighten their balance sheets of inventory
toward the end of reporting periods (e.g., quarters, fiscal years)?

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Managing Supply and Suppliers

Lecture 18

W hen most people think of purchasing, procurement, or supply
management, they think of the department responsible for buying
the “stuff’—raw materials, spare parts, and so on—that feeds
the business. This function doesn’t sound especially interesting until we
consider the fact that supply management can render the company profitable
or unprofitable based on the terms negotiated with suppliers; it also serves
as the gatekeeper of quality, in this lecture, we’ll explore how effective
supply management practices can be leveraged not only to keep the business
running but also to set it apart from others. We’ll examine fundamental
questions surrounding what to buy, how to select suppliers, and how to make
good suppliers excited to get your company’s business.

The Evolution of Supply Management

• The traditional role of the purchasing department in an organization
was to acquire the necessary materials, goods, and services to
feed the operation and to do so at the lowest possible prices. Over
time, purchasing evolved into procurement, which expanded the
set of purchasing activities and elevated the strategic focus of the
tasks. Beyond merely “buying stuff,” procurement professionals
assessed the quality of competing suppliers and established supplier
qualifications and material specifications.

• Over the past two decades, procurement has given way to modern
supply management, which is even more strategic for the business
and collaborative with suppliers. Supply management seeks to
achieve competitive advantage by working effectively with choice
suppliers, even engaging suppliers early in the development of
new products and services. These days, supply management not
only controls a considerable share of the company’s budget, but
it influences the competitiveness of the company through its
connection with other business strategies and departments.

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Lecture 18: Managing Supply and Suppliers

• One industry phenomenon that has accelerated the influence of
supply management is the rampant adoption of outsourcing over
the past three decades. As we’ve seen, companies are electing to
outsource activities that they no longer view as their strengths,
and with this decision, the role of supply management expands.
Supply management usually assumes responsibility for selecting
the outside suppliers, negotiating the arrangements, and monitoring
the provision of services.

Centralized and Decentralized Supply Management

• Once a company determines what it will buy, the supply
management organization can take shape. Critical to forming the
organization is understanding the scope of the work required. If the
company operates from multiple locations, how much responsibility
will rest with a central purchasing organization and how much
will rest with buyers at each location? Organizations opting for
centralized control decide what to buy, select the suppliers, and
initiate the orders, all from headquarters. Field personnel verify that
the quantity and quality of supplies meet expectations but do not
make strategic decisions.

o The benefits of such a system include consolidating the spend
and ensuring that the company achieves volume discounts
from suppliers and high-priority service by virtue of putting
large chunks of the business in the hands of fewer suppliers.
Centralized control can also support greater standardization
of supply across various field locations. The disadvantage of
a centralized system is that it doesn’t allow field operations
to exert their influence on suppliers or to address their
specific needs.

o In contrast, decentralized control allows the field locations to
act autonomously, to freely choose suppliers and to negotiate
directly with them. Although the individual needs of the
locations can be addressed in these arrangements, the volume
of the spend may not be sufficiently large to warrant the most
competitive price or highest-priority service from suppliers.

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• Most good-sized companies pursue a blended strategy, which
involves headquarters centralizing the planning of supply and field
locations controlling the buying actions. Such arrangements try
to achieve balance between the control of centralization and the
flexibility of decentralization, though strategic decisions are left
with headquarters.

Supplier Relationship Strategies

• A company’s strategy for engaging suppliers is based in large part
on what is purchased. Most companies must acquire “mission-
critical” supplies—items that influence the quality of the products
and services the company provides or that are visible to customers.
The opposite of these visible and mission-critical items are the
invisible, commodity items. Whereas a firm might emphasize
quality with mission-critical items, price might be the highest
priority with commodity items.

• The amount of attention directed toward supplier relationships also
depends on how critical the supplies are to a company’s products
and services. A supplier of maintenance, repair, and operating
supplies that don’t go directly into a product typically doesn’t
warrant the same attention as a supplier that can help a company
win or lose in the marketplace.

• How many suppliers of a given input is ideal? Competing theories
weigh in on this question.

o Some believe that fewer suppliers is better, even going so far
as to recommend sole sourcing. The benefit of this approach
is that the spend is concentrated in one place, which should
elevate the volume discount. It’s also easier to manage one
supplier than several.

o However, the dependency inherent in sole-sourcing
arrangements drives many supply professionals away from
pursuing them. Placing all of a company’s business for a
given input in the hands of a single supplier may eliminate the
positive influences of competition on price and quality.

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Lecture 18: Managing Supply and Suppliers

• Another school of thought on the ideal number of suppliers seeks
to incite a feeding frenzy among multiple suppliers. The belief is
that this situation intensifies competition and encourages suppliers
to cut prices to the bone. This is usually a short-term proposition,
however, because suppliers are interested in large chunks of
business that are repetitive, allowing them to smooth their own
operations and reduce transaction costs.

• Often a “middle-ground” strategy is preferred. Most progressive
companies avoid sole sourcing where possible, yet they’re not
constantly on the prowl for new suppliers. Rather, they examine the
portfolio of items and services they buy and look for opportunities to
consolidate the spend, which will provide leverage in negotiations.
They also look for opportunities to collaborate with suppliers of
critical parts.

Selecting Suppliers

• It has become common for large supply management organizations
to spend a preponderance of their time qualifying suppliers, that
is, establishing standards for doing business with the company. In
light of the vast interest in serving large companies, corporations
use qualification as a way to filter the interest, requiring
prospective suppliers to meet standards in quality, capacity, safety,
and ethical performance.

• Once the qualifications are in place, a company can approach
the supply market. Of course, the method of approach depends
on both the company’s situation and what it is buying. Seasoned
buyers often know who to contact first—which suppliers have the
capabilities, capacity, and pricing to be competitive. In some cases,
a company might set up a reverse auction, inviting select players to
compete in real time for the business and choosing the supplier that
brings forward the lowest price.

• If simply putting the business out to bid and shopping for low
price is not the answer, then companies may have to take an
intermediate step to see what prospective suppliers have to offer.

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This process involves “interviewing” suppliers through a request
for information (RFI), a request for quote (RFQ), or a request for
proposal (RFP).

Total Cost of Ownership

• In making supplier selections, most companies today are looking
beyond purchase price. Instead, they’re considering what’s
known as the total cost of ownership (TCO) associated with the
purchase. This is a way of bringing a life-cycle perspective into the
procurement of goods and services.

• The life-cycle perspective makes sense because TCO considers not
only the purchase price but all the costs associated with acquisition,
such as the costs of financing the purchase and preparing the
business to use the materials or products. To that end, TCO also
factors in the costs of use, including the cost of carrying inventory.

• But it’s in the determination of a product’s post-use factors that
the life-cycle perspective of TCO can alter the landscape of the
purchasing decision. These post-use factors include the costs of
dissatisfied customers, such as warranty, recall, or liability costs,
as well as the environmental impacts of products and packaging
material in the post-use phase.

• In sum, the life-cycle perspective espoused in TCO revolutionizes
the act of buying. It’s a 180-degee turn from traditional purchasing
practice and requires much deeper thought than simply shopping
for prices and specs ever accommodated.

Keeping Suppliers Engaged

• One tip for keeping suppliers engaged and working hard for
your firm is to maintain open communications, especially with
suppliers that are critical to your business. Invite suppliers to tour
your facilities and request a tour of theirs. Seeing the products and
services in use can inspire discussion and illuminate opportunities
for improvement.

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Lecture 18: Managing Supply and Suppliers

• You should also provide
regular feedback to all strategic
suppliers. Issue a monthly
supplier scorecard, for instance,
to rate performance on a few
metrics that are important to
your business and explain, in
general, how the supplier is
doing. The basic dimensions
of performance usually include
quality, cost, and delivery.

• Progressive companies also
turn the mirror around and ask
suppliers how satisfied they
are with the focal firm as a
customer. Such assessments
usually examine the ease
of doing business with the
customer and are generally
conducted by third parties.

• Leading-edge companies are
also moving toward supply
chain competition. Companies no longer compete merely head
to head but also supply chain to supply chain, pitting their entire
input-to-delivered-output systems against those of their rivals.
With that in mind, there’s a race to win the best, most innovative
suppliers. These are the suppliers that possess unique intellectual
property, processing capabilities, and branding to bolster your
products and services.

Providing a scorecard for
supplier performance should
serve as a conversation starter,
enabling both parties to see the
potential for improvement and
to develop a mutually beneficial
relationship.

• Beyond working with suppliers, you want to enlist them to help
you compete. This can take the form of early supplier involvement,
where suppliers help to devise the next generation of products and
services, it may result in joint-venture opportunities or licensing

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KatarzynaBialasiewicz/iStock/Thinkstock.

arrangements when the market proves promising. At a minimum,
the involvement of suppliers early in the new product development
process can highlight the limitations or challenges that you’ll
encounter should you elect to proceed with a bold new technology.

Suggested Reading

Ellram and Krause, “Robust Supplier Relationships.”

Ellram and Siferd, “Purchasing: The Cornerstone of the Total Cost of
Ownership Concept.”

Monczka, Handheld, Giunipero, and Patterson, Purchasing and Supply
Chain Management.

Tate, The Definitive Guide to Supply Management and Procurement.

Questions to Consider

1. How has supply management progressed beyond the tactical activity of
buying?

2. Why is it important to engage other business functions in strategic
conversations with suppliers?

3. What are the risks of having too few and too many suppliers of a
critical input?

4. How does the lifecycle perspective of TCO change the orientation of a
buying organization?

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Lecture 19: The Long Reach of Logistics

The Long Reach of Logistics

Lecture 19

■

L ogistics is the business function responsible for ensuring that the
right products are available in the right quantities at the right place
and time to meet customer expectations. The field of logistics
embraces the transportation and distribution of products, but it’s something
more: It’s the overarching planning, timing, optimization, and coordination
involved in getting products where they need to be, when they need to be
there. In this lecture, we’ll examine three key aspects of logistics: the role
of logistics in providing the company’s “reach” in the market through its
chosen distribution strategy, the logistics network required to support the
distribution strategy, and the operational aspects of logistics—the movement,
storage, and technology used to meet customer requirements.

Distribution Strategies

• Distribution refers to the spreading of product throughout the
marketplace so that a large number of people can buy it. it
encompasses the warehousing, transportation, and tracking of
goods into the marketplace, all of which requires strategy. We’ll
begin by considering three distribution strategies: intensive,
exclusive, and selective.

The business of logistics is substantial: About $1.4 trillion is spent each year in
the United States alone to support the storage and transportation of goods.

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• Some businesses, such as Coca-Cola or General Mills, aspire
to have their products in the hands of every customer in a region
or market. This is called intensive distribution. In order for these
companies to earn sizeable profits on their narrow margins, they
must sell tremendous volumes of their products. In essence, they use
intensive distribution to “blanket the market” with their products.

• At the opposite extreme from intensive distribution is exclusive
distribution. This strategy involves getting products in the hands of a
limited number of people but offering a “high-touch” or customized
buying experience. This approach is often associated with high-
priced luxury goods, such as jewelry, fashion merchandise, and
sports cars. Manufacturers that use exclusive distribution tightly
control production and distribution. They either distribute the goods
themselves or align with a limited number of distributors and retailers.

• The third strategy, selective distribution, fits somewhere between
the intensive and exclusive distribution approaches. Companies
pursuing selective distribution have more customers than exclusive
providers and fewer than intensive competitors. Distribution might
be selective in terms of the number and types of customers reached
or in tenns of the locations served.

• Depending on the desired intensity of the market coverage, any one
of these three alternatives might support a company’s competitive
basis—how it intends to “win” in the market. And many companies
employ multiple distribution strategies, using different approaches
for different brands under the company’s umbrella.

Logistics Networks

• The term logistics networks refers to the locations from which a
business operates and the functions or purposes of those locations.
Every business must consider the network over which it wants
to conduct business such that it: (1) reaches customers with its
products and (2) can access key sources of product supply. It’s
here we realize that logistics is involved in both the inbound and
outbound sides of the business.

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Lecture 19: The Long Reach of Logistics

• Finding the right number and placement of locations involves not
just science but art.

o The art comes in the sense of importance that is imparted
to customers by establishing a store or warehouse location
near them or by setting up a convenient catalog or website
ordering system.

o Yet it’s impossible to be located close to all customers when
they’re scattered about a large geographic area. This is where
companies rely on science to figure out how to achieve the
greatest reach with the fewest facilities. The goal here is the
optimal blend of market access and cost containment.

• The science of logistics has its origins in military science, and
commercial enterprises have borrowed the idea of the center of
gravity from military strategists.

o In the military, the center of gravity of an enemy is its
concentration of forces in a conflict; it represents a source
of vulnerability.

o In business, the center of gravity represents the best place
to locate a distribution point given the inbound supply and
outbound distribution locations. It’s the optimal point at which
the total distance that must be covered in from supply locations
and out to demand locations is minimized. To serve large
markets, most businesses elect to operate from several locations.

• Competition can also fuel the need to increase the number of
distribution and store locations. When a rival establishes a presence in
a market, it creates a need to match the competitor’s strategic move.
Restaurant chains and retailers routinely demonstrate this behavior.

• Of course, there are a few checks on the logic of adding more
locations to a logistics network. For instance, more facilities means
a higher warehouse and real estate investment, and a company can
expect to invest more in inventory as it adds distribution points in
its network.

138

o It has been proven that a company will need more safety stock
inventory when it adds locations to its network. Safety stock
is the inventory held just in case there’s an increase in demand
or a delay in supply. This is opposed to cycle stock, which is
inventory a company maintains to cover itself for forecasted
sales and normal supply lead times. The greater the uncertainty
a company faces, the more safety stock it requires.

o The square root rule predicts that the amount of safety stock
a company holds will double when the number of locations
quadruples. In other words, if a retailer increases its store count
from one location to four, the safety stock inventory held across
the four stores will be twice as much as when the company had a
single location. This expected increase in inventory discourages
companies from adding too many facilities to their networks.

o Transportation costs can also make adding too many
distribution points unattractive. Adding locations means that a
company also has to ship to those locations. Even though the
company gets closer to customers on the outbound side of the
business, inbound transportation costs can be prohibitive.

o The final check on the logic of adding locations to better serve
a market is cannibalization. When sales flatten and saturation
is achieved in the market, any sales gain for one location is
accomplished at a loss to another location. Obviously, when
the gain comes at the expense of a competitor, that’s good. But
when it comes at the expense of a company’s partner locations,
there may be little or no benefit.

• Determining the “right” number of locations is something of a
moving target for many companies because markets are dynamic
and logistics networks are fairly permanent or, at least, costly to
change. To help accommodate the need to expand and contract
logistics networks, some businesses seek the help of third-party
logistics providers (3PLs), which own warehouse and transportation
assets to help their clients expand and contract as needed.

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Lecture 19: The Long Reach of Logistics

• In lieu of outsourcing, some companies work with distributors and
wholesalers to achieve broader coverage in a larger market than
they could attain on their own. This practice is known as using
indirect channels of distribution.

o The obvious disadvantage to such arrangements is that the
company loses direct touch with the end customer, who now
buys from the intermediary.

o In addition, the intermediary is likely to also sell products
offered by competitors. Consequently, the manufacturer must
try to appeal not only to the end customers but also to the
intermediaries in the hopes that they’ll stock and actively sell
the firm’s products.

Operational Factors

• Once a company has its distribution strategy and logistics network
in place, it must turn to the operational side of logistics: delivering
to customers or store locations. Here, the focus is on the order cycle,
or lead time, which is the amount of time from order receipt to
delivery. Much of the execution in this stage of the logistics process
rests with transportation, which represents what is often called the
“last mile” segment of the order cycle: the physical delivery of
goods on time and safely to customers.

• Choosing the right means of transporting goods can have major
cost and service implications for a company. Naturally, speed and
dependability usually come at a higher price. It may cost 70%
more to ship a product the next day to a customer than to use two-
day delivery. There are five basic modes of transportation, each
with its own cost and service implications: truck, rail, air, water,
and pipeline.

o Truck transportation is the most common means used today,
given that it is so readily available and is generally regarded as
fast and reliable.

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o Air transportation tends to be preferred for time-critical
deliveries that must cover long distances, such as urgent cross¬
country or international shipments. High-value goods, such
as consumer electronics and pharmaceuticals, often move by
plane, as do highly perishable items (e.g., fresh-cut flowers) or
products with short market life-cycles (e.g., fashion apparel).

o Transportation by railroad is popular for shipments that allow
for longer transit times over longer distances, such as hauling
grains from Iowa to New York or coal from West Virginia
to Arizona.

o Transportation by water, including rivers, great lakes, and
oceans, is preferred for the transport of massive quantities
of goods when time is not critical and navigable waterways
connect the origin and destination points.

o Finally, pipeline transportation is currently limited to
commodities that are fluid in nature, such as oil and gas.

• Sometimes, the best transportation solution involves combining
modes for shipment in what’s known as intermodal transportation.
Although most items will move by truck at some point in their
distribution, this mode of transportation can be expensive, energy
intensive, and environmentally unsound. For these reasons, rail
may be used more often in the future.

• The future could also be marked by new modes of transportation,
such as the unmanned aerial drones—small programmable
helicopters—that Amazon is experimenting with for home
deliveries from order fulfillment centers. Experiments are also in
place to test underground pipelines for shipping nonliquid cargo
and blimps for moving large cargo over oceans.

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Lecture 19: The Long Reach of Logistics

• Advanced technologies in information systems are also influencing
logistics activities. These technologies include transportation
and warehouse management systems, as well as communicative
technologies, such as the Internet, GPS, and RFID, used to link
companies, enhance information exchange, and improve visibility
of supply and demand across companies. In sum, there is immense
change altering the logistics landscape and the means by which
companies achieve “reach” in the market.

Suggested Reading

Arvis, Saslavsky, Ojala, Shepherd, Busch, and Raj, Connecting to Compete
2014.

Goldsby, Iyengar, and Rao, The Definitive Guide to Transportation.
McGoldrick and Barton, “High-Tech Ways to Keep Cupboards Full.”
Murphy and Knemeyer, Contemporary Logistics.

Questions to Consider

1. How does effective logistics management affect a company’s ability
to compete?

2. Is logistics becoming more or less important in today’s marketplace?
Why?

3. Can you think of an example where poor logistics execution ruined
your day?

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Rethinking Your Business Processes

Lecture 20

V irtually everything we do involves a process, whether it’s filing a
legal brief, performing a surgical procedure, or making a product.
But even though they go on all around us, we tend not to think
deeply about processes or even notice them. In business, however, finding
ways to improve processes has become indispensable to success. Companies
use process thinking to determine what work really needs to get done and
how to get the most of their available time and resources. This perspective
focuses company efforts on the outcomes that create defensible value. In
this lecture, we’ll explore this concept and look at some simple tools for
improving the processes that matter to your organization.

The Voice of the Customer and the Voice of Business

• It’s often said that there are two voices we should listen to when
making any business decision: the voice of the customer and the
voice of the business. The voice of the customer tells us what
customers are seeking in the way of product or service attributes
and, more importantly, the outcomes they want to have fulfilled
through the products and services they buy. Those outcomes, given
a price the customers pay for them, render an assessment of value;
therefore, value is defined as “quality given the price paid.”

• Outcomes speak to the question: Does the product use or service
experience satisfy—or better yet—delight the customer? To address
outcomes, it’s useful to take the time to listen to customers and
understand their needs before engaging in a series of hit-and-miss
“improvements” that might miss the mark!

• The voice-of-the-customer concept reminds us that the “right
things” for a business to do should be in line with providing
outcomes that customers want and are willing to pay for. This last
piece—the “paying for”—brings in the voice of the business.

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Lecture 20: Rethinking Your Business Processes

o This voice directs our attention to such needs as revenue,
profitability, growth, image and stature, meaningful jobs for
employees, and so on. In order for a business to survive and
thrive, it must look after these needs.

o Thus, the “right things” for the business to pursue are those
that generate value in the eyes of customers and generate the
business outcomes the organization needs.

Process Mapping

• Once you’ve figured out what outcomes to pursue—the “right
things”—the next logical question is how to do these things
“right,” that is, how to achieve efficiency and effectiveness in the
work processes performed. The first step here is to understand the
current state of your processes, starting with those that are in clear
need of help.

• The next step is to make the chosen process visual by capturing it in
a process map. You can make this diagram using software or draw
it out on a large sheet of paper or poster board. It’s helpful to get the
various people involved in the process to help you devise the map.
The example on the following page is a process map for taking a
trip by commercial airline.

o The experience of taking an airline flight is captured here in
eight steps: (1) researching the ticket, (2) buying the ticket,
(3) getting the boarding pass, (4) clearing security, (5) walking
to the gate, (6) boarding the plane, (7) riding out the flight,
and (8) and collecting luggage. Limiting the process map to
between 8 and 12 steps is usually good enough for a first pass;
you can always add more detail later if you find a trouble spot
requiring deeper analysis.

o Note that step 4, acquiring the boarding pass and checking
luggage, involves another party, the airline ticket agent. The
involvement of other actors or locations in the process is
delineated in a swim lane, an additional line of actions that

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Customer

Research

Ticket

Buy

Ticket

Prepare
and Pack

Get

Luggage

PT: 10 min
WT: 2 days
FTQ: 80%

Avail.: 98%

Value: NO

PT: 10 min

WT: 3 wks

FTQ: 95%

Avail.: 99%

Value: NO

PT: 1 min

WT: 0-30 min

FTQ: 98%

Avail.: 98%

Value: YES

Ticket Counter

Get Boarding
Pass

PT: 5 min

WT: 0-1 hr

FTQ: 98%

Avail.: 95%

Value: NO

Security

Clear

Security

PT: 2 min

WT: 0-1 hr

FTQ: 95%

Avail.: 95%

Value: NO

Concourse

Walk
to Gate

PT: 10 min

WT: 0-2 hr

FTQ: 99%

Avail.: 95%

Value: NO

Boarding Gate

Board

Plane

fe. Fly to
Destination

PT: 3 min

WT: 0-30 min

FTQ: 99.9%

Avail.: 99%

Value: NO

PT: 2 hr

WT: 0

FTQ: 100%

Avail.: 99%

Value: YES

runs parallel to the main line. Each actor in the process has his
or her own swim lane, as does each physical location. When
the process moves from one actor to another, the transition is
shown by drawing a line from one swim lane to another.

• The first pass at the process map does not mark the end of the
review but, rather, the beginning. To the extent that others are
involved in the process, you should confer with them to see if
their version of the process jibes with yours and to discuss and
resolve discrepancies. This discussion may reveal important
misunderstandings or conflicts that stand in the way of
process improvement.

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Lecture 20: Rethinking Your Business Processes

Process Time, Wait Time, and Cycle Time

• Once agreement is reached on the first-pass map, it’s a good time
to reflect on the process as a whole, asking whether any steps or
even the whole process could be eliminated. If you determine that
the process remains essential, it’s time to do a deeper analysis by
populating the basic work steps with additional data, such as the
amount of time required to complete each step (process time). You
can also estimate the amount of time spent waiting within each step
and between the various steps.

• In our air travel example, the sum of the process times across the
eight steps is 161 minutes. Remember, this is the actual amount
of time in which the actors in the process are engaged in work
associated with booking the flight, reaching the plane, taking
the flight, and collecting luggage. Of these 161 minutes, 120 are
associated with the flight itself. The total wait time across the
process is 23 days and 5 hours.

• The sum of the process and wait times is the cycle time for
the process—the total time elapsed from process initiation to
conclusion. In our example, the cycle time is 33,581 minutes. Note
that the vast majority of cycle time is associated with the three-
week period that elapsed between buying the ticket and taking the
trip. Of the more than 33,000 minutes, only 161 involve actual
work performed by the key actors in the process. This amounts to
just under 0.5% of the total cycle time!

• The wait time for a flight might strike you as normal, but you
might be surprised to learn that such a low level of time efficiency
is common in both personal and business work processes. In fact,
it’s rare to find a measure of time efficiency greater than 10%. This
speaks to the considerable slack time found in most processes. A
process map helps to illuminate such wasted time.

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First-Time Quality and Resource Availability

• Two other important factors to consider when analyzing processes
are first-time quality (FTQ) and resource availability. FTQ refers
to the percentage of time that a given work step is completed
successfully on the first try. Resource availability refers to the
percentage of time that the various resources required to perform a
work step are available.

• The FTQ and availability levels for the whole process are calculated
by multiplying together all the percentages for each factor.

o In our scenario, the FTQ for the process is 68.6%. In other
words, about 70% of the time everything about the flight
process goes according to plan. The other 30% of the time,
something goes wrong somewhere in the process.

o Multiplying the availability percentages across the eight steps
yields a total availability for the process of 79.9%.

• With the calculated totals for FTQ and availability in hand, look
for the culprits that could affect these two outcomes to the greatest
extent. In the case of FTQ in our scenario, researching the ticket
(80% FTQ) is a major contributor to quality failure. Meanwhile,
availability suffers somewhat at the ticket counter, the security
checkpoint, and the departure gate—all locations where lines form
and travelers must wait.

• Bear in mind that yields for FTQ and availability will only decline
or, at best, sustain overall performance when more work steps are
identified in a process. This is not only a mathematical reality of
multiplying their values but also an operational reality. The more
complicated a process becomes, the more opportunities for error,
delay, and disruption are introduced. With that in mind, it’s wise to
try to simplify processes by reducing the number of steps involved.
This, in fact, is a principle of Lean Thinking.

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Lecture 20: Rethinking Your Business Processes

Labeling Work Steps

• To help in identifying which steps to eliminate from a process, Lean
Thinking recommends assigning a subjective label to each work
step. That subjective label is whether or not the step is a value-
added one. In other words, does the step contribute defensible value
to the process?

• If the elimination of a step would diminish the value of the process
outcome in any way, it should be labeled “value added” and should
remain intact in the process. In fact, you might explore ways in
which you can add even more value through such a step. But if you
can eliminate a step without interfering with the process, it should
be labeled “non-value added.”

• Note that some steps in the process may be non-value added but
still necessary, such as observing laws and safety measures. These
steps should be labeled “essential (or necessary) non-value added.”
Still, you should look for ways to reduce the time invested in these
work steps.

• In our example, we might identify only two steps as value added:
the air travel itself and collecting the luggage at the destination. In
other words, travelers want to reach their destinations safely and
find their suitcases on the baggage carousel; everything else in the
process merely assists in making those outcomes possible.

o These two value-added steps account for only 121 of the more
than 33,000 minutes of the process; thus, the value-added time
accounts for only 0.36% of the total cycle time. This low value
is not out of the norm for such an analysis.

o Unfortunately, the six non-value-added steps are essential
to taking the trip, but ample opportunities for improved
efficiency might still be found. For example, a traveler could
use a smartphone to check in for the flight, streamlining the
collection of the boarding pass. The point here is that all
the steps in the process should be scrutinized for potential
improvements.

148

• Adding the “value-added” and “non-value-added” labels converts
the process map to a value stream map. This in-depth assessment of
the current state of the process allows you to identify trouble spots
or unnecessary steps in the process. You might also go a step further
and create a future state map that adjusts the process to fit your
vision. If the outcomes are commensurate with or exceed the value
of the time, effort, and resources invested, then you can redefine
how the work should be conducted in the future.

Suggested Reading

Dennis, Lean Production Simplified.

Garvin, “The Processes of Organization and Management.”
Martichenko, Everything I Know about Lean I Learned in First Grade.
Rother and Shook, Learning to See.

Staats and Upton, “Lean Knowledge Work.”

Questions to Consider

1. What is the value of visualizing a process by mapping it?

2. What should you take away from a process map that reveals that a
process is performing at a throughput efficiency (ratio of value-added
time to total cycle time) of less than 1%?

3. How should management address a situation where most of a person’s
work time is devoted to non-value-added work?

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Lecture 21: Measuring Operational Performance

Measuring Operational Performance

Lecture 21

A performance measure is an expression of the health or vitality of an
activity or process performed by an individual, a team, or an entire
organization. Similar to measures of health for people, such as
body temperature or pulse rate, business measures should be quantifiable—
expressed in numbers. Metrics should also be precise and reliable; two people
monitoring the same attribute should be able to arrive at the same reading.
Finally, metrics should be easy to collect and understand, both effective and
efficient in the information they convey. In this lecture, we’ll look at some of
the most meaningful measures to track in order to support your business.

The Balanced Scorecard

• Performance measures express the priorities of the organization
and provide practical guidance for the work performed every day.
Rewards and punishments are often based on how individuals perform
against established, communicated standards. A good place to start
when devising a performance measurement scheme is to reflect on
your organization’s vision and supporting strategies: What is it that
you’re trying to accomplish? What outcomes are you seeking, and
what behaviors do you need from people to achieve them?

• In the 1990s, Robert Kaplan and David Norton devised a framework
for performance measurement called the balanced scorecard that
lays out four areas with which a company should concern itself for
long-term growth and success: financial performance, customer
assessment, internal business processes, and learning and growth.
All four dimensions of the balanced scorecard are focused on the
organization’s vision and strategy.

Financial Performance

• Financial measures are absolutely essential for any business, and all
companies use several of them. Among the most important financial
metrics are measures of profitability, including profit margin

150

and operating margin. Others include measures of management
effectiveness and measures taken from the company’s income
statement, balance sheet, and cash flow statement. These metrics
provide meaningful insights from the perspective of shareholders
and others with a financial interest in the company.

• From an operational standpoint, it’s important to take a deeper look
at the financials and try to interpret where your company may be
overextended or lacking coverage in its operations,
o For instance, you can divide the revenue figure from the
income statement by the inventory figure found on the balance
sheet. As we learned previously, this gives you inventory turns,
a measure of the efficiency of your operations.

If you generate $100,000 in sales and you hold $20,000
worth of inventory, on average, you achieve 5 inventory turns
(100,000/20,000). If you can generate the same $100,000 in sales
with only $10,000 worth
of inventory, on average,
then you achieve 10
turns and can claim to be
twice as efficient from
an inventory standpoint.

Getting by with less
inventory while still
serving the customer
well allows you to
free up cash that can
be used in other ways
in the business. Retail
organizations often use
a similar measure for
the efficiency of the company’s salesforce by dividing sales by
the number of employees to get a sales-per-employee metric.
Again, the more sales you can generate with fewer employees,
the more efficient your business.

When used in combination with other
data points, financials can offer rich
insights, both for those outside and
inside a business.

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Lecture 21: Measuring Operational Performance

• Finally, for publicly traded companies, the share price is considered
to be the most efficient measure of financial health. The share price
reflects the net present value of all future cash flows on a per-share
basis and serves as a comprehensive measure of past, present, and
anticipated future results.

Customer Assessment

• Customer satisfaction is the most common measure for the
customer perspective of a business. To gauge it, marketers
embrace a theory called the expectancy-disconfirmation paradigm.
According to this theory, customer satisfaction is a result of the
degree to which consumer expectations are either confirmed or
discontinued by actual experiences with a product or service.
When the perceived performance of a product or service meets or
exceeds customer expectations, the customer is said to be satisfied.
When perceived performance falls short of expectations, the
customer is dissatisfied.

• Satisfied customers are believed to become loyal customers, who
are often the most profitable segment for any business. Marketing
to loyal customers costs less because they already know and like
your company and its products and services; loyal customers
tend to be resistant to the counterclaims of your competitors;
they’re often willing to be early adopters of new products and
services; and they offer positive word-of-mouth endorsements
to others.

• Companies measure customer satisfaction in different ways, but
these measures almost always involve asking the customer how
the business performed, usually following a specific transaction.
Marketing researchers have learned that a single question offers
a good read on satisfaction: “How satisfied were you with your
recent experience?” More questions may be added to learn
about specific aspects of the transaction. Answers are usually
scored on a 5-point or 10-point scale to assess the relative degree
of satisfaction.

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• A metric called the net promoter score (NPS) is gaining a great
deal of interest these days as a meaningful measure of satisfaction.
Here again, one question is used: “How likely is it that you would
recommend [our company] to a friend or colleague?” Customers
respond on a scale of 0 to 10, and the NPS is calculated by subtracting
the percentage of detractors (respondents showing scores of 0 to 6)
from the percentage of promoters (those with scores of 9 or 10).

• Customer loyalty, as opposed to customer satisfaction, is best
measured through actions rather than sentiments. Most telling is
the percentage of repeat customers that your business enjoys. Still,
it’s important to continue asking customers about their levels of
satisfaction and to keep monitoring behavior because customers’
tastes and competitors’ offerings can change over time.

• Interestingly, many companies today are trying to determine the
cost of poor service, also known as the cost ofpoor quality (COPQ).
This metric teeters on the financial side of the balanced scorecard
but is squarely focused on the cost of disappointing customers. It
asks: What is the lost revenue if we disappoint a customer and he or
she returns or cancels an order?

Internal Business Processes

• The traditional metrics for business processes examine their
productivity and efficiency. Productivity can be equated to the
yield of a process. A process that generates a great deal of output
is said to be a productive process. Efficiency, in contrast, looks
at the amount of output given some level of input. A process that
generates the same output as another but with fewer inputs is
regarded as more efficient.

• More recently, the operational excellence philosophies of Lean
Thinking and Six Sigma are yielding valuable insights on the
management of business processes. In fact, they deemphasize the
traditional focus on productivity and efficiency in favor of waste
elimination and variation reduction.

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Lecture 21: Measuring Operational Performance

• As we’ve said, Lean Thinking is the management philosophy
that seeks to eliminate waste in its various forms throughout the
business. The seven forms of waste are captured in the acronym
TIM WOOD, which stands for transportation, inventory, motion,
waiting, overproduction, overprocessing, and defects.

• As we’ve also seen, Six Sigma seeks to reduce variation. It relies on
a five-step procedure for identifying improvement opportunities and
seeing them through to implementation and sustained performance.
The procedure is called the DMAIC method , for define, measure,
analyze, improve, and control. The second phase of this method,
measure, underscores the importance of assessing a process in
its current state, as it undergoes improvement, and in sustaining
improved perfonnance.

o A primary measure in the Six Sigma assessment is defects per
million opportunities (DPMO). A defect is a work step that
falls outside of established tolerances.

o Six Sigma performance dictates an extremely low level of
defects: 3.4 DPMO. The more defects found in a process,
the lower the sigma level. A process performing at 1
sigma, for instance, allows more than 691,000 defects per
million opportunities!

o Highly automated manufacturing processes stand the best
chance of achieving Six Sigma-level quality. Processes that
rely more on human effort tend to have lower thresholds.

Learning and Growth

• The final dimension of the balanced scorecard framework is
learning and growth. This perspective focuses on the knowledge
and capabilities of the people that make up the business. This
seems to be the least developed aspect of the framework, although
concerted effort has been made in recent years to better understand
what drives an employee and to align employees’ interests and
skills with the needs of the organization.

154

• The traditional focus of HR departments was recruiting new people
into the organization and included such metrics as recruitment
yield ratio, average time to fill a job vacancy, cost per hire, and
employee turnover rate. Increasingly, however, HR departments are
broadening their purview to include retention and the development
of human capital. Measures in these areas might include voluntary
and involuntary termination rates and average tenure.

• Metrics for employee development include training costs or
investment per employee, hours of training, and employee
assessments of satisfaction with training and development, as well
as advancement opportunities within the organization.

• Both Lean Thinking and Six Sigma incorporate the human element
in process achievement. Lean Thinking, in particular, brings a
strong focus on safety and morale in the workplace. Common
metrics here include days worked without a lost-time accident,
number of reportable incidents, and near-misses. Closely related
to safety is morale, which is often measured through a survey
conducted by an outside party.

Sustainability

• A new frontier for performance measurement in business today is in
the area of sustainability: the idea of operating a company so that it
and the world around it both have healthy futures.

• Noted author John Elkington, in his book entitled Cannibals with
Forks, prescribes a triple-bottom-line approach to measuring
sustainable business performance.

o The first bottom line is the economic one. As we’ve said, in
order for any organization to thrive and survive, it must be able
to sustain itself economically.

o The second bottom line is dedicated to the environment. An
organization that considers the long-term environmental
consequences of its actions will be a better corporate citizen
and a company that people want to buy from and invest in.

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Lecture 21: Measuring Operational Performance

o The third bottom line is that associated with the societal impact
of business activity—the question of how various people are
affected by business activities. This bottom line seems to lag
behind the other two, but it is important to devise appropriate
metrics to guide decision making on this critical dimension of
business endeavor.

Suggested Reading

Epstein and Buhovac, Making Sustainability Work.

Kaplan, Norton, and Rugelsjoen, “Managing Alliances with the Balanced
Scorecard.”

Kiron, Kmschwitz, Haanaes, and von Streng Velken, “Sustainability Nears a
Tipping Point.”

Peloza, Loock, Cerruti, and Muyot, “Sustainability: How Stakeholder
Perceptions Differ from Corporate Reality.”

Reichheld, “The Microeconomics of Customer Relationships.”

Questions to Consider

1. What is meant by the expression “What gets measured, gets done”? How
do performance measures influence behavior within an organization?

2. How does the balanced scorecard approach provide a 360-degree
assessment of business health? Are there any aspects of business vitality
that this measurement framework fails to address?

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Keeping an Eye on Your Margins

Lecture 22

T he gross margins of a business, which show the percentage of total
sales that constitute profit, are fairly easy to calculate using the
income statement. However, determining where the contributions
to gross margin come from—in terms of products, services, and individual
customers—is anything but routine. In fact, probably no more than 15% of
companies determine profit contribution on a customer-by-customer basis.
Instead, many just assume that all business is good. In this lecture, however,
we’ll pinpoint more precise numbers that show how different customers
affect your business and force you to consume resources.

Customer-by-Customer Contribution Analysis

• In a start-up business, the relationship between how a business
expends its resources and how it generates income may be fairly
easy to see, but as the business grows, it may need a more advanced
level of margin analysis. This analysis can be generated by product,
product line, service, or customer. When examining customers, the
focus is on the products and services that each customer buys.

• Consumer service organizations, retail businesses, and online
retailers don’t generally run a unique analysis for each customer.
Instead, they look at types of customers and what these types
typically ask for and buy in the way of products and services. This
is what marketers call segmenting the customer base —breaking the
market up into small groupings of customers that look and act alike
in terms of what they demand and buy.

• With a business that sells to other businesses, however, the customer
count is probably much lower; these firms sell larger volumes to a
smaller number of customers. But very large business-to-business
marketers may still have a customer count that numbers in the

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Lecture 22: Keeping an Eye on Your Margins

thousands, which would also require some segmentation. In either
scenario, business-to-business sellers should isolate their largest
customers and segment the remaining ones.

• For most companies, the 80-20 rule applies. This rule suggests
that 80% of a company’s revenues come from 20% of its
customers. In other words, a relatively small number of customers
is disproportionately important to the business in terms of how
revenues are generated. These vital few customers that generate
massive sales are the ones that call for individualized attention.
Keep in mind, however, that your focus here should be on margin,
not sales.

Differential Resource Consumption

• What really matters in a contribution analysis is reaching an
understanding of differential resource consumption, that is, figuring
out which customers force a business to consume what resources. To
appreciate this idea, let’s contrast it with traditional cost allocation
methods, specifically, average costing. As its name implies, average
costing simply divides a cost by the number of customers served to
arrive at an average cost.

o Consider, for instance, the cost of answering a customer’s
inquiry over the phone. The average cost method would simply
look at all the costs associated with customer phone inquiries,
including the cost of the call center facility, the phone lines,
and employee time, and divide this sum by the number of
inquiries made by customers.

o But the average costing method is sorely lacking in accuracy
and insights. It implies that all customer transactions are
equally resource intensive, and often, that’s not the case; not all
customers consume resources equally.

o However, when you rely on average costing to drive decisions,
you’re making that assumption: that service provisions
consume resources equally across customers. As a result.

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companies that rely on average costing are subsidizing their
most taxing customers. In other words, customers that don’t
ask for much pick up part of the tab for demanding customers.

• This is a major problem because most companies assume that their
biggest customers—the ones that generate the most revenue—are
the best customers in terms of profit contribution. Yet many of
these big customers can be fairly demanding to serve. And when
you apply charges for the resources they force you to consume,
you might find that these “big sales” customers are not the most
profitable ones.

• Instead, when you focus on what activities you perform for which
customers, you get a much richer understanding of how resources
are consumed. As a result, you can be much more informed about
how to dedicate your resources.

Cost-to-Serve Analysis

• A cost-to-serve analysis is one that expresses the cost of serving
specific customers or, when that’s not possible, the cost to serve
different groups or types of customers who behave in a similar
fashion. When you subtract the cost to serve a customer from revenue
earned on the business, you arrive at the customer contribution.

• The first step in this analysis is to get a handle on business resources
and expenses. Review the balance sheet for the resources and
examine financial reports, such as the statement of cash flows and
general ledger, to see how money is spent.

• Second, examine the activities performed in the business. In
operations, the focus tends to be on the activities from order
placement through delivery and collection of payment, such as order
processing, production, fulfillment, and delivery. Of course, other
activities that take place before the order and after payment, such as
sales and marketing, can also be incorporated. The point here is to
hone in on the activities that are unique or involve different types or
levels of resource consumption across the different customers served.

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Lecture 22: Keeping an Eye on Your Margins

• By linking the first step (related to resources) to the second step
(related to activities), you can devise a cost per activity. The
method used to translate resources to costs is borrowed from a
technique called activity-based costing (ABC). As its name implies,
ABC focuses on the activities a business performs and how these
activities consume resources.

Activity-Based Costing

• An activity-based analysis typically focuses on one of two cost
objects', products or customers. Thus, you can focus either on how
resources are consumed to produce products and services or on how
resources are consumed on a customer-by-customer basis.

• In linking resources to activities, it’s helpful to generate a process
map of the activities you perform for your customers. You can then
link the resources (and ensuing costs) to each step in the process.
What people and materials are involved, and how much of each
goes into delivering the outcome of the activity?

• One way to simplify this analysis is to focus on a single cost driver
for each activity—something that strongly influences the activity’s
cost. As the driver activity increases or decreases, the activity cost
follows suit.

o Consider the activity of delivering goods to customers. If your
company delivers over long distances, such as across states,
then distance may a good cost driver. But if you deliver locally
(or in a small region), then time might be a better cost driver.

o The determination of the proper or best driver is a judgment
call and not always obvious. The goal is to strive for consensus
rather than perfection in determining cost drivers.

o Let’s say that your company spent $20,000 on customer
deliveries last month, including the cost of fuel, equipment
maintenance, and personnel costs, and covered 10,000 miles.

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Let’s also say that the cost driver chosen for delivery expense
is mileage. Dividing the $20,000 delivery expense by 10,000
yields a standard cost of $2.00 per mile for each delivery.

o You would make similar calculations for the variety of
activities performed in customer transactions to arrive at a cost
for each activity, such as cost per order acquisition, production,
invoicing, and so on.

• Finally, we arrive at the third step in the analysis: determining
the cost to serve each of the customers and segments. Here, you
need refer to existing records of how much activity goes toward
each customer. What you’ll find is that different customers demand
different levels of activity. Each customer should be assigned
costs only for the activities performed for that customer. This
is a departure from average costing, where costs are assigned
to customers irrespective of the specific service provision and
activities performed.

o Suppose you deliver to a customer located 30 miles away (60
miles roundtrip). Applying the $2.00 per mile calculated earlier,
each delivery to that customer costs $120.00. In contrast, a
customer who picks up an order at your warehouse incurs no
delivery costs.

o By marrying the cost per activity and activity level for each
customer, you get the cost per activity for each customer.
You can then sum up the costs across the various activities
performed for each customer to arrive at the total cost to serve
that customer per transaction.

• Two important points to keep in mind in conducting the cost-to-
serve analysis are these: (1) Don’t quibble about every penny in the
analysis, and (2) include only the costs that would be eliminated if
the cost object went away.

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Lecture 22: Keeping an Eye on Your Margins

o Going back to the delivery example, would you shut down the
warehouse or reduce the size of the production facility if you
lost a specific customer? The answer is probably not. Don’t
worry about how to split up the fixed costs of the facility when
doing this analysis.

o In essence, what that means is that you’re conducting a
contribution analysis instead of a fully loaded profit-and-loss
analysis. You will still have to consider how to cover your
facility and other fixed costs, but the contribution analysis will
help you understand which customers are contributing to the
coverage of these fixed costs.

Using the Analysis

• With this initial analysis,
you can start to understand
where your business is
“winning” and “losing”
on a customer-by-customer
basis. What would you
do, for instance, if you
discovered that a sales
transaction for which you
charge a customer $300
per order actually costs you
$350 to fulfill?

• One answer is to eliminate
unprofitable customers,
but that’s not advisable
unless you have other
highly profitable customers
waiting in the wings. A
better solution is to make
the underperforming customers profitable. The first option here
might be to make internal changes that would allow you to perform
the service more cost effectively.

Rewards programs and store loyalty
memberships represent one approach
to offering differential pricing in
business-to-consumer marketing.

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• Another option, of course, is to raise prices to gain margins or to
adjust the product or service. You could take these actions across
the board, affecting all customers, or you could offer different
products, services, and/or prices to different customers. This is an
age-old practice in business-to-business marketing, where there is
low transparency in the market in terms of what different customers
receive and at what price.

• The insight you gain by comparing customer demands and
resource consumption can allow you to move to a more menu-
based arrangement for your products and services. That should
ensure that every one of your business’s transactions has a fair
shot at profitability.

Suggested Reading

Cespedes, Dougherty, and Skinner, “How to Identify the Best Customers for
Your Business.”

Cooper and Kaplan, “Measure Costs Right.”

-, “Profit Priorities from Activity-Based Costing.”

Garrison, Noreen, and Brewer, Managerial Accounting.

Kaplan and Anderson, Time-Driven Activity-Based Costing.

Questions to Consider

1. Is it possible for your biggest customers (in terns of sales) not to be
your best customers? How so?

2. How does activity-based costing differ from traditional average costing?
In particular, how are the assumptions different?

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Lecture 23: Leveraging Your Supply Chain

Leveraging Your Supply Chain

Lecture 23

A mong the most pervasive developments in business over the past few
decades is the emergence of supply chain management (SCM), but
there is much confusion surrounding the exact meaning of this term.
It appears to involve a great deal of action—warehouses moving products
along high-speed conveyors, giant cargo ships cruising the ocean—and
extensive arrays of information technologies. That impression isn’t entirely
wrong, but a more complete understanding of SCM can illuminate why
every organization needs to assess its supply chains to leverage the potential
for competitive advantage. In this lecture, we’ll look at the distinct discipline
of SCM as a higher order of operations management.

Supply Chain Management as a Team Sport

• As you’ll recall, a supply chain is the network of companies
that works together to provide a good or service for the end-use
market—individual consumers or businesses and institutions.
SCM is the discipline of managing the network of suppliers and
customers to achieve the greatest possible effectiveness for the
benefit of your organization.

• It should be clear that for your organization to “win” in the long¬
term, it’s essential to work with strong suppliers and customers.
But it’s also essential that those outside parties benefit from
arrangements with your organization. In this sense, SCM should be
considered a team sport.

• One example of this approach can be found in the efforts of
Coca-Cola and Pepsi to develop an alternative to corn syrup as a
sweetener for their soft drinks.

o Coca-Cola worked closely with a major supplier of corn syrup,
Cargill, to develop Truvia, a sweetener made from the stevia
plant. Pepsi was also interested in the stevia plant, but because

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Cargill was already spoken for, Pepsi had to find another
partner. As a result, its competing product, PureVia, didn’t
reach the market until almost two years after Truvia.

o What’s interesting about this example is that it’s not just a
story about competition between two companies but about
competition between their supply chains.

• Even Wall Street is catching on to the importance of SCM. A
company’s value is no longer tied merely to past performance
and expectations for the future in terms of new products on the
horizon. The relationships that the company forms with its strategic
customers and suppliers also factor into its worth. A company with
a better portfolio of customers or favorable relations with the best
suppliers will be valued more highly than its competition.

• When you accept that SCM is a team sport, you’ve adopted
what’s called a supply chain orientation. A company with a supply
chain orientation looks to leverage the capabilities and resource
advantages offered by its outside partners in the supply chain.

Understanding the Network Structure

• The first step in leveraging your company’s supply chain is to
understand its network structure. From whom do you buy from, and
to whom do you sell? The answers to these questions represent your
tier-1, or immediate, suppliers and customers. A good idea is to map
out this series of upstream and downstream relationships.

• Begin with your downstream customer relations. Are there some
customers that are more important to your business? What share
of your business goes toward these customers? As we’ve seen, it’s
quite common for 80% of a company’s revenues to come from 20%
of its customers.

o Once you understand who your customers are and the volume
and nature of the business you do with them, you should step
back and think about how comfortable—or uncomfortable—
that portfolio of customer relationships makes you feel.

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Lecture 23: Leveraging Your Supply Chain

o Are there customers on whom you feel overly dependent? Are
there opportunities that appear to be left on the table? These are
the relationships that call for more attention.

• With regard to those relationships on which you feel overly
dependent, a simple yet powerful expression comes into play:
P AB = D ba , in which P is power, D is dependence, and A and B
are two independent parties. According to this expression, the
power that A has over B is a function of how dependent B is
upon A.

o When one company is very dependent on another—in our
equation, B is very dependent on A—then A can exert a great
deal of power in its dealings with B. This can manifest in
many ways: pricing and sales terms, delivery options, and so
on. In extreme situations, the power imbalance can border on
abusive relations; for example, a powerful customer might
demand pricing concessions, unique services, and high levels
of relationship-specific resources.

o In these circumstances, it’s essential for a company to
understand its cost of doing business and to know when it
must push back against a customer. Beyond mere resistance to
egregious customer demands, the company can also step back
and think creatively about how some sense of power balance
can be achieved in the relationship. Can the company make
itself indispensable to the customer in at least one category
in which it competes for the customer’s interest? Many small
firms have been successful with this tactic.

• This equation of power and dependence also applies to relationships
with suppliers. Your company should assess its relative position
with suppliers, determine which suppliers are most important for
the business, and figure out how to become the preferred customer
to these critical suppliers.

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• Research shows that the highest-performing business relationships
are those in which there is a level of codependence. When the
dependence goes only one way, then the powerful party will usually
extract everything it can from the relationship, and the weaker party
will be regarded as dispensable.

Forming Strategic Relationships

• It isn’t possible—or advisable—to form strategic relationships with
each of your customers and suppliers because such relationships
require a great deal of investment. Forming a strategic relationship
might involve dedicating a team of people with specific skill sets to
an important account or dedicating a customer service line for the
exclusive use of valuable customers. Certainly, not every customer
warrants such an investment. The solution here comes down to a
fundamental economic question: How can you best employ limited
resources for the greatest benefit?

• When extensive investment is not possible or deemed worthwhile,
you might dedicate a single individual to the account and be willing
to offer some unique products and services. For your remaining
customers, you should try to be easy to do business with, offering
convenient store hours, an online presence, and customer service
personnel, but you provide little in the way of customization or
unique resource investment.

• Be especially careful when assessing the value of a customer
relationship. If you rely solely on past sales, you might overlook
tomorrow’s stars. When the Solo Cup Company first had to decide
whether to work with Starbucks, the coffee giant was a small, local
operation with only seven stores. Had Solo passed on Starbucks’
business at the time, it might not be the primary provider to the
more than 18,000 Starbucks locations today.

• Use similar thinking when considering supplier relations. Some
suppliers are more important than others and deserve extra attention.
These might be suppliers that provide unique materials; offer higher

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Lecture 23: Leveraging Your Supply Chain

quality or better value; or possess intangibles, such as innovation in
products and processes. There may also be troubled suppliers that
are essential to your business yet are straggling with quality, cost,
or delivery. These suppliers may deserve extra attention, too. The
management of supplier relationships requires an understanding of
which outside entities are poised to help you most—not only today
but into the future.

Internal and External Integration

• The Global Supply Chain Form at Ohio State University has
helped to define the field of SCM with a framework built on eight
key business processes. The first two processes in this framework
focus on rightsizing customer and supplier relationships: customer
relationship management (CRM) and supplier relationship
management (SRM).

o The six additional processes are customer service management,
demand management, manufacturing flow management, order
fulfillment, product development and commercialization, and
returns management.

o Although CRM and SRM represent the key linkages in the
supply chain, the other six processes represent the work that
must take place across functions to create and transfer value
through engagement in the supply chain network, especially
with select suppliers and choice customers in the network.

• In case it’s not already obvious, SCM should not be the work of
a single department in a company, even though a company might
have a department that has “supply chain” in its name. The Global
Supply Chain Forum believes strongly that SCM requires the
involvement of all business functions if an SCM team is to make
the right decisions for a business, determine how to compete,
and produce the greatest possible returns for the company and
its shareholders.

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• In this way, SCM is really a team sport on two levels: through
internal integration, which requires coordinating all the functions
within the company, and through external integration, which means
leveraging business relationships with choice customers and select
suppliers—figuring out how to go to market together.

• Small businesses have some advantage when it comes to internal
integration. They can usually align themselves better and faster than
their larger, more complex competitors. Decision making is usually
more concentrated in smaller firms, and arguably, employees
demonstrate a greater concern for the success of the business. Where
there is better internal integration, the company is poised to realize
the greatest benefits of integration with external partners.

• In contrast, large companies are often laden with bureaucracy that
makes internal integration more challenging. However, they may
find it easier to collaborate with outside companies because of their
economic power and size. Large companies are also more likely to
invest in integrative technologies and to dedicate teams of people to
important business relationships

that warrant the investment.

• Even though your company may
not have fully dedicated suppliers
or customers that promise not to
buy from your competitors, SCM
and the teamwork it involves can
still be beneficial. The linkages
in the supply chain network
convey much more than product
flowing from one company to
another and cash flowing in the
reverse direction. In some sense,
participants in these networks
are bound together and share a
common identity ... as if they’re
playing on the same team.

The rewards for forming
mutually beneficial relationships
with the best suppliers and
customers include improved
economic returns, innovation,
adaptability, and growth.

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Lecture 23: Leveraging Your Supply Chain

Suggested Reading

Fisher, “What Is the Right Supply Chain for Your Product?”

Lambert, Supply Chain Management.

Lambert and Knemeyer, “We’re in This Together.”

Lee, “The Triple-A Supply Chain.”

Simchi-Levi, Clayton, and Raven, “When One Size Does Not Fit All.”

Questions to Consider

1. Why is it important for a company to understand the supply chain
network in which it operates?

2. What does it mean to say that there is equity in supply chain relations?

3. Flow can your restore balance in a supply chain relationship when the
level of dependence is not in your favor?

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Reducing Risk, Building Resilience

Lecture 24

A mong the hottest topics in business today is risk management.
Risks are found in situations with uncertain outcomes, and
given the rate of change in the world today, our businesses are
laden with uncertainty. The media is full of examples of companies that
fail to take something into consideration—something for which they are
held accountable or something that goes seriously wrong on their watch.
Further, studies have shown that a “bad day” for a business, such as a delay
in production or delivery, can result in a drop in the firm’s stock price,
on average, of 10%. In this lecture, we’ll look at approaches for at least
dampening the effects of potentially perilous situations.

Internal Risks

• The first step in risk management is to conduct a 360-degree scan
of your organization or environment. In conducting such surveys,
business strategists often use a SWOT analysis, examining strengths,
weaknesses, opportunities, and threats. Strengths and weaknesses
are assessments of the internal condition of the organization, while
opportunities and threats are external to the company.

• Weaknesses represent the internal risks imposed on the business,
many of which we’ve already explored: departmental conflict, an
inattentiveness to mission, the inability to change, and complacency.
Internal weaknesses can be among the most difficult to identify and
measure. Symptoms may persist for quite some time before they
result in a noticeable problem.

o To aid in the recognition of symptoms before they become
problems, many companies today use a tool called failure
mode and effects analysis (FMEA), which helps to identify and
prioritize risks.

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Lecture 24: Reducing Risk, Building Resilience

In this type of analysis, a failure mode is anything that could go
wrong in a business—something that falls short of expectations
or performance standards. A failure effect is an outcome or
consequence of the failure mode.

o FMEA provides a scoring system for prioritizing the risk
factors that call for the greatest attention.

• The first step in the FMEA process is to brainstorm across the
range of failure modes. The range can run the gamut from everyday
occurrences to the seemingly outlandish. The idea is to capture all
the possibilities, which will be evaluated in the next step.

• After a failure mode is identified, concern is focused on three
attributes associated with it: (1) probability of occurrence, (2)
severity with occurrence, and (3) ability to detect occurrence. A
simple subjective scoring system ranging from 1 to 10 is usually
sufficient for evaluating these three attributes. The composite of the
three scores is the risk priority number (RPN).

o Imagine that a certain risk rates 10 across the board, meaning
that it’s highly probable, perhaps inevitable; is extremely
severe when it occurs, perhaps resulting in fatalities; and is
very difficult to detect at the time of occurrence. The RPN is
this case would be: 10 x 10 x 10 = 1,000.

o The higher the RPN, the more the issue calls for immediate
attention. Keep in mind that the objective is not to achieve
100% accuracy but to shine a light on the most significant
risk factors.

• In addition to conducting FMEA, your organization can take
additional internal steps to make itself more agile and resilient.
For example, you can implement information technologies that
make you aware of internal and external circumstances calling for
attention. You should also establish a high level of communication
across departments and functions to facilitate information sharing.

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You can cross-train your employees to take on different roles and
tasks, so that they’re aware of each other’s priorities and can fill
in for each other in case of a crisis. Such steps can elevate your
company’s ability to sense and respond to challenges.

External Risks

• One of the most common sources of external risk is the supply
chain. As you recall, the supply chain is the network of companies
that work together to provide a good or service for the end-use
market. Virtually every company exists within, and depends on, a
network of companies to create and deliver value in the market. We
all exist within this ecosystem of supply chains.

• Although outsourcing is common in many industries today,
we’ve seen that it is not an effective strategy for pushing off risk,
especially if it’s your brand on the product or if you sell directly
to end customers. Your company will be held accountable—if not
in the judicial system, then in the court of public opinion—for any
egregious act perpetrated in the provision of the product.

• When assessing opportunities and threats in light of this network
orientation, it’s wise to map the network, just as you would do in
analyzing your company’s internal processes. (See below.)

Supplier A
Supplier B

Supplier 1

Supplier A - Supplier 2

Supplier 3

Supplier A
Supplier B
Supplier C

Supplier 4

_ Your _
Organization

Customer 1
Customer 2 ^
Customer 3
Customer 4
Customer 5 ^
Customer 6
Customer 7-

Customer A
Customer B

Customer A

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Lecture 24: Reducing Risk, Building Resilience

The first pass of the supply chain map is dedicated to simply
identifying who makes up the chain, focusing on a single product
or service offered by your organization. Suppliers that provide
material inputs to support this offering are your immediate, or
tier-1, suppliers. Where you might have many different suppliers
of a given input, group them together. Alternatively, you might
have one supplier that provides many different inputs.

o Once you have a satisfactory diagram of tier-1 suppliers, add
your tier-1 customers, those who buy this product or service from
you. You may want to list important customers individually.

o Next, see if you can identify tier-2 suppliers, those who support
your tier-1 suppliers. They may be difficult to identify unless
they brand their components or products. Connect the tier-2
suppliers to the appropriate tier-Is that they serve. For those
you cannot identify, try to list the ingredient, component, or
input that feeds your suppliers at the tier-1 level.

o Next, list your tier-2 customers. Similar to tier-2 suppliers,
these companies are likely to be more difficult to identify,
especially if they’re mass-market consumers.

• Once you have the map drawn out, step back and take a critical
look at it. Who are your most critical suppliers and most valuable
customers? Where are you most dependent in your relationships or
even overly dependent?

o You might find yourself overly dependent on one or a few
key customers. If one customer represents more than 20% or
25% of your sales, that’s a sign that you should diversify your
customer portfolio.

o You want to be able to direct your capacity toward the
best-paying opportunities, but you don’t want to be overly
dependent on one or a few key customers. That situation puts
you in a weak bargaining position. At a minimum, you want to
engender a level of codependency in these arrangements.

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• Likewise, you may be overly dependent on one or more suppliers,
on individual ingredients that go into your products, or on the
locations that supply them.

o Consider the case of rare-earth minerals, metals that are used
extensively in advanced consumer and industrial technologies.
These minerals are difficult to extract from the earth and rather
dirty and costly to process. Environmental regulations in the
United States have made it economically unviable to mine
these materials here.

o As a result, the world has become dependent on suppliers
in China, where environmental laws are not so stringently
enforced. It’s estimated that even though China is endowed
with about half of the world’s natural supply of these rare-
earth minerals, Chinese companies supply about 96% of the
world market.

o This realization puts manufacturers of technological products
ill at ease. Do they want to be so dependent on one nation for
supply? This can be especially problematic when a foreign
government elects to impose tariffs and quotas, dramatically
altering the availability and price of supply. Alert companies
are determined to engineer these materials out of their
products. Clearly, this calls for a cross-functional team to
identify different materials that might serve the purpose of the
original ingredient.

• Other instances calling for awareness of the reach of supply
chains can come from state, national, and international regulatory
requirements. For example, the California Transparency in Supply
Chains Act of 2010 requires large retailers and manufacturers doing
business in California to disclose their efforts to eradicate slavery
and human trafficking from their direct supply chains for all the
goods they offer for sale.

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Lecture 24: Reducing Risk, Building Resilience

• Where you have difficulty mapping critical supplies and customers,
it illuminates a need for understanding and, possibly, greater
controls. For example, one finding that is quite common in supply
chain mapping is the revelation of common sources of supply at the
tier-2 level.

o In an effort to avoid overdependence at the tier-1 level, you
might buy from two or more tier-1 providers of the same input.
Yet when mapped beyond tier-1, the supply chain might show
that your tier-1 suppliers are buying from the same supplier at
tier 2.

o Therefore, if disruption occurs with the tier-2 supplier, all
your tier-1 suppliers of this item could be paralyzed, making
you as vulnerable as if you had only one tier-1 supplier. This
circumstance is uncovered only if you can map your supply
chain beyond the tier-1 level.

Environmental Risks

• Along with mapping your supply chain, it’s a good idea to do a
360-degree scan of your environment to identify risk factors other
than those residing with suppliers and customers. These include the
risks that competitors can present, risks found in the markets and
economies in which you operate, or risks that may be introduced by
social change or government actions. The FMEA tool can be helpful
in conducting this external assessment and prioritization of risks.

• By brainstorming, you can identify a diverse array of risks,
everything from everyday occurrences to the extremely rare. The
military characterization of events as known-knowns, known-
unknowns, and unknown-unknowns can be helpful here. Known-
knowns are events that have some precedent and might even be
explained or predicted. Known-unknowns are events that have been
identified but happen rarefy and, hence, have little supporting data.
Unknown-unknowns are events that can only be imagined, having
no recorded history.

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• When you brainstorm about your company’s risks, you may
discover some that are interdependent. You might find, for instance,
that by eliminating one risk, you elevate or introduce another. One
risk common to all businesses is a stockout, and one way to address
this risk is to hold large quantities of inventory. Yet inventory
comes with a cost; thus, by reducing one risk, you elevate another.
The name of the game in risk management is usually to offset an
unacceptable risk with a more acceptable one.

• Once you have a strategy for embracing challenges, try to form
strategic relations with your most critical suppliers and prized
customers. Such connections enable you to mitigate risks and make
it difficult for competitors to emulate your success in good times
and bad.

Suggested Reading

Driscoll, “Why Companies Keep Getting Blind-Sided by Risk.”
Gardner and Cooper, “Strategic Supply Chain Mapping Approaches.”
Reeves and Deimler, “Adaptability.”

Saenz and Revilla, “Creating More Resilient Supply Chains.”

Sheffi and Rice Jr., “A Supply Chain View of the Resilient Enterprise.”
Simchi-Levi, Schmidt, and Wei, “From Superstorms to Factory Fires.”

Questions to Consider

1. Is it possible to eliminate the risks that a business faces?

2. What is a failure mode? How can FMEA be used to manage risks in
business?

3. What can a company expect to learn from a supply chain map as it
relates to vulnerabilities and risks?

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Critical Business Skills:
Finance and Accounting

Eric Sussman, M.B.A.

Critical Business Skills: Finance and Accounting

Scope:

A ccounting and finance are two of the cornerstones of any business
school curriculum—and for good reason. Accounting, often called
the language of business, provides the means by which organizations
communicate—in facts and figures—how effectively they are fulfilling their
strategic missions and operating objectives by providing critical information
to current and prospective investors, creditors, and regulators. Accounting
rules and standards provide the framework by which individual transactions
are recorded in financial records and consolidated into financial statements,
including the income statement, balance sheet, and statement of cash flows.

Finance is all about decision making—how accounting information,
financial statements, and economic data are used by individual investors,
business owners, and corporate finance personnel to decide whether to
make a particular investment; how to raise capital needed to run or expand
operations and the trade-offs of each; how to value stocks, bonds, or other
cash-producing assets and optimally place them in a diversified portfolio; and
how to more appropriately assess the relationship between risk and return.

These 12 lectures are designed to summarize and present critical theories,
vocabulary, and real-world applications from both disciplines. The overall
goal of this section of the course is to help you make better and more
informed investment decisions, whether you are an individual investor
seeking to understand how the companies you’re interested in are performing,
a business owner seeking to improve your accounting and finance skill set or
to more effectively interact with and manage accounting and finance staff, or
simply someone who wants to further his or her business education.

This section of the course is structured in two parts. The first six lectures
focus on key issues in accounting to enable you to become a more informed
reader of financial statements and accounting information released by
companies in which you might have an interest. In Lecture 25, we introduce

181

Scope

generally accepted accounting principles, the primary standards under which
most U.S. companies account for, record, and consolidate transactions into
their financial statements.

In Lectures 26 through 28, we analyze the income statement, balance
sheet, and statement of cash flows in depth, introducing key accounting
definitions along the way. In Lecture 29, we discuss ratio analysis, a useful
tool that allows us to use financial statements to evaluate an organization’s
profitability, efficiency, liquidity, and risk, while allowing comparisons to
other organizations, including competitors. Finally, in Lecture 30, we discuss
breakeven analysis and introduce the concept of contribution margin.

The second six lectures focus on key concepts in finance: the time value
of money and how to discount future cash flows to their present-value
equivalents, how to think more formally about the relationship between
risk and return, and the trade-offs for firms deciding whether to use debt or
stock to finance their businesses. Along the way, we will introduce important
finance terms, such as net present value and the internal rate of return,
common measures used to evaluate investment opportunities. Finally, we
will discuss how to value stocks.

These lectures are designed not only to introduce you to the theoretical
concepts in both accounting and finance but to provide practical and concrete
examples for applying both disciplines in your everyday life. ■

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Accounting and Finance—Decision-Making Tools

Lecture 25

T he year 2008 was one most investors would like to forget. The
investment bank Bear Stearns was sold at a fire-sale price to J.P.
Morgan in March 2008. Then, Lehman Brothers filed for the largest
bankruptcy in U.S. history. The country faced its greatest financial crisis
since the Great Depression. Many people have since asked whether these
events were foreseeable, and an examination of Lehman Brothers’ financial
statements from 2007 clearly reflects the likelihood that the company would
fail. One lesson we can learn from these failures is that it is our job to
understand the accounting and financial reporting issues of the companies in
which we invest. In this section of the course, we will tackle that task.

Defining Terms

• Accounting is the language of business. It’s an important means
by which organizations communicate to key constituents—in facts
and figures—how they are performing and how effectively they are
fillfilling their strategic goals and objectives.

o The key constituents within and external to any organization
include employees, management, clients and customers,
shareholders, lenders and creditors, members of the board of
directors, and even taxing authorities. All these constituents
have an interest in the financial performance of organizations
with which they are invested or involved.

o Employees, managers, and executives need to plan and control
operations, manage resources, evaluate capital needs, and make
important strategic decisions. Investors and creditors, including
trade suppliers and lenders, must evaluate the company’s
financial strength and performance to know whether to lend or
invest capital in the organization.

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Lecture 25: Accounting and Finance—Decision-Making Tools

o How do these constituents make their decisions and
evaluations? The answer is through accounting data. These data
tell stories that are crucial to understanding the overall fitness
of a company. In fact, if you review the financial statements of
any organization, you should be able to discern a tremendous
amount of information about it, including its profitability, the
effectiveness of its asset management, how it is funded, and
more.

• Finance puts the language—the stories—of accounting to
practical use. It focuses on how accounting information is used
to make certain decisions. These decisions might include whether
a particular investment opportunity makes sense and should
be pursued; how best to raise capital needed to run or expand
operations; how to value stocks, bonds, or cash-flow-producing
investments; and so on.

Standard Accounting Disclosures

• Companies are required to provide annual reports to shareholders,
and in the United States, they file the equivalent, a Form 10-K, with
the Securities and Exchange Commission (SEC), generally within
60 to 75 days after the end of the fiscal year. Annual reports must
include an overview of the company’s business and operations,
discussion and analysis of financial results, financial statements
and related footnotes, an independent audit report, and several
other disclosures. The four financial statements disclosed in annual
reports are the balance sheet, income statement, statement of cash
flows, and statement of shareholders’ equity.

• The balance sheet is often called the statement of financial position;
it details what an organization owns—its assets—and what it
owes—its liabilities and debts. All the information on the balance
sheet is as of a particular point in time, typically the end of a fiscal
quarter or year.

o If assets exceed liabilities on the balance sheet, the difference
is called shareholders ’ equity. If liabilities exceed assets, the
difference is called a shareholder deficit.

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In addition to public companies, many other organizations, including
municipalities, nonprofits, and some private firms, must also prepare annual
and audited financial statements.

o The balance sheet helps tell us how liquid an organization is,
how much it has invested in working capital (for example,
inventory and accounts receivable), how much debt it has, and
therefore, how leveraged or risky it appears to be.

• The second financial statement is the income statement, often called
the statement of operations, the profit and loss statement, or the
statement of revenues and expenses. It includes such key metrics as
revenues, net income, and earnings per share,
o Unlike the balance sheet, which is prepared as of a particular
point in time, the income statement reflects operations during
a particular period of time, typically a quarter or a year. It
starts with revenues, subtracts costs and expenses, and ends
with net income or loss (or net surplus or deficit for nonprofit
organizations). The income statement is the accountant’s
best effort at measuring the economic performance of an
organization during a given period of time.

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1 Alexandr Dubovitskiy/iStock/Thinkstock.

Lecture 25: Accounting and Finance—Decision-Making Tools

o Although the income statement tells us about an
organization’s profit or losses, it does not tell us about the
organization’s actual cash flows. That is, we cannot look at
an organization’s income statement and discern whether it is
generating or bleeding cash. The reason the income statement
doesn’t give us that information is that it is required to be
prepared using the method of accrual accounting, rather than
cash-based accounting.

o Under the rules of accrual accounting, a company is allowed
to recognize revenue from a sale as soon as it delivers its
products to a customer, whether or not the company actually
receives cash from the sale at the time of delivery. Thus, any
company that complies with generally accepted accounting
principles (GAAP) will report profits or losses on its income
statement that differ from cash flows, and these differences can
be material.

• As a result, organizations must also provide another kind of
financial statement, the statement of cash flows. This statement
reports, for a certain period of time, the amount of actual cash either
generated or consumed by an organization. As we will discuss, the
statement of cash flows provides two key pieces of data for users of
financial statements.

o First, it lays out the differences between reported profits or
losses under accrual accounting and the actual cash inflows or
outflows of the organization during that same period. Second,
it segments the cash flows into three distinct categories:
those from operating activities, investing activities, and
financing activities.

o Operating activities are supposed to reflect cash inflows or
outflows from normal and recurring operations. Investing
activities should capture the cash inflows or outflows from a
company making nonrecurring investment decisions, including
the purchase of property, plant, or equipment; mergers and
acquisitions; or even the investment of excess cash into stocks

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and bonds. Financing activities should reflect cash inflows
and outflows from transactions involving a company’s lenders
and shareholders, such as the issuance of stock or bonds, the
payment of dividends, or the repurchase of company stock.

o The statement of cash flows is extremely important because it
tends to be the most objective of the financial statements. It
also serves as a crucial link to valuation.

Accounting Myths

• Many people seem to believe that because accounting involves so
many numbers and figures and is rule based, it must be scientific
and objective. Unfortunately, that isn’t the case. In fact, there are a
number of estimates that pervade financial statements, and plenty
of judgment and subjectivity are involved in applying particular
accounting rules.

• In addition, people often assume that there is one most important
figure—revenues, net income, or some other metric—that investors
and others should look at to evaluate financial performance.
Unfortunately, there is no single measure that allows an overall
assessment of financial performance. Some metrics or disclosures
might be more important than others, but it is crucial to take a
holistic approach to analyzing financial statements.

• Another myth regarding accounting is that companies should have
only one set of accounting records. Having more than one set of
books might sound like fraud, but in fact, it’s business as usual. For
example, most organizations have at least two sets of accounting
records, one for creditors, lenders, and shareholders, and the other
for tax authorities.

o The rules concerning how transactions are reported to
shareholders and how they are reported in tax returns are not
the same. For example, firms can report one set of profits to
shareholders and another, much lower, set to tax authorities.
This may not be surprising given that tax authorities and
accounting regulators do not have identical objectives.

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Lecture 25: Accounting and Finance—Decision-Making Tools

o For instance, in 2013, Apple reported pretax earnings of $50.2
billion to shareholders; on that level of earnings, Apple paid
$13.1 billion in taxes. That represents only 26.3% of pretax
profits, far lower than the top federal tax rate of 35%.

o The company obviously took advantage of various tax
loopholes and rules to avoid paying some taxes. There is
absolutely nothing inherently illegal or improper about that,
and in fact, Apple’s CEO, Timothy Cook, has testified before
Congress on this issue, stating that the company was complying
with tax laws and taking advantage of the rules as written. The
important thing for us to keep in mind is that the Financial
Accounting Standards Board and the Internal Revenue Service
often do not see eye to eye.

• Finally, it’s not true that the financial statements tell us how much
a company or organization is actually worth. For example, the
balance sheet may indicate what a firm owns and owes, but most
assets are not reported at their fair market values. Further, some
valuable assets—particularly intangible assets, such as patents,
trademarks, and copyrights—might be omitted from the balance
sheet entirely.

o Consider, for instance, the Apple logo, the Coca-Cola brand
name, or Mickey Mouse. Obviously, these are three of the most
valuable intangible assets in the world, each worth billions of
dollars. Their owners generate significant profits and cash flows
from them, but these assets are not recorded on the financial
statements of the companies that own them.

o The problem here is that there is no truly objective means of
valuing these intangible assets; for this reason, accountants
have decided not to record them on financial statements.
Thus, to estimate the value of a company, we need to use
the available accounting information and make appropriate
assumptions and adjustments.

188

• As we move forward in these lectures, we’ll explore even more
of the interesting and informative analyses we can perform by
applying some fundamental lessons in accounting and finance, with
the goal of improving our financial decision making in business and
in life.

Suggested Reading

Collins, Johnson, Mittelstaedt, Revsine, and Soffer, Financial Reporting and
Analysis, chapters 1-2.

Easton, McAnally, Sommers, and Zhang, Financial Statement Analysis and
Valuation, chapter 1.

Questions to Consider

1. Why do you think the regulators, including the SEC and the Federal
Reserve, missed the clear indications of risk evident in the financial
statements of Lehman Brothers, Bear Stearns, and AIG?

2. Pick a publicly held company you currently own stock in, have owned
stock in sometime in the past, or are contemplating investing in
sometime in the near future. Find the company’s most recent annual
report or Form 10-K on its website (generally in the investor relations
section). Open up the document and see if you can find the company’s
five financial statements. Take a look at the income statement and
determine whether the company reported a net profit or loss in the most
recent year.

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Lecture 26: How to Interpret a Balance Sheet

How to Interpret a Balance Sheet

Lecture 26

I n the last lecture, we introduced some key concepts in accounting and
finance and explained why these disciplines are critically important
topics that all investors and businesspeople should understand. In this
lecture, we will take a deeper dive into the balance sheet, the financial
statement that details what an organization owns and what it owes as of a
particular point in time, typically, the end of a quarter or year. The balance
sheet is important because it provides clues about an organization’s financial
stability, its risk, and its liquidity, that is, its ability to meet its short- and
long-tenn financial obligations.

• Intel’s 2013 balance sheet
presents two reporting
periods, one ending
December 2013 and one
ending December 2012.
This is typical for all
organizations and lets
us compare numbers
over time. Note, too,
that all the figures on
Intel’s balance sheet are
presented in millions.

Even individual households should have
a sense of their assets and debts to
optimally manage their finances, invest
appropriately, and plan for the future.

Balance Sheet Overview

• As most of us know, Intel is a manufacturer of microprocessors,
chips, and other products used in various technology applications.
Its consolidated balance sheet, along with its other financial
statements, can be
found on the company’s
website, in the investor
relations section.

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• On the balance sheet, Intel’s assets are listed first, followed by
liabilities and stockholders’ equity. Remember that stockholders’
equity is the difference between the total amount of assets and the
total amount of liabilities. By definition, therefore, assets must
equal the sum of liabilities and shareholders’ equity. The relatively
simple formula Assets = Liabilities + Equity is sometimes called
the basic accounting equation.

• Finally, note that the assets and liabilities are divided into two
distinct categories: current and noncurrent. The dividing line
between current and noncurrent on any balance sheet is 12 months,
o Thus, a current asset is something that is liquid, something

that can or will be used within 12 months. On Intel’s 2013
balance sheet, the current accounts receivable is $3,582
billion. That’s the amount owed by Intel’s customers that is
expected to be collected within 12 months following the date
of the balance sheet.

o Similarly, the current liabilities are amounts that Intel expected
to pay to others during the 12 months following December 31,
2013. Specifically, Intel owed $2,969 billion to its vendors and
suppliers as of the end of 2013, which it expected to pay before
the end of 2014.

o By definition, then, any items below “Current assets” are things
that are expected to last longer than a year, and items below
“Current liabilities” are amounts expected to be paid after a year.
Examples of noncurrent assets would include property, plant,
and equipment—the fixed assets of any organization—while an
example of a noncurrent liability would be long-tenn debt.

Current Assets

• On the asset side of the balance sheet, assets are ordered from the
most liquid to the least liquid, starting with current assets. Thus, on
almost every balance sheet, the first asset to appear under “Current
assets” is cash and cash equivalents.

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Lecture 26: How to Interpret a Balance Sheet

Cash equivalents are essentially any risk-free securities with
a maturity date of less than 90 days. Examples might include
money market accounts, a three-month certificate of deposit
from a bank, or a U.S. treasury bill.

o Clearly, the cash balance is important because it gives us a
sense of how much cash the organization has at the end of the
reporting period and, of course, how that balance compares to
the prior year.

• Other assets that typically make up current assets include
marketable securities—any stocks, bonds, or other liquid
investments the organization might own. The sum of the cash, cash
equivalents, and marketable securities gives a sense of the liquidity
of an organization. Different organizations label these marketable
securities differently in their balance sheets. Intel, for example,
refers to them as “Short-term investments.”

• Accounts receivable—amounts owed to the company by its
customers—typically follow marketable securities on the balance
sheet.

o As mentioned, Intel’s balance of accounts receivable at the end
of 2013 was about $3.6 billion. On the company’s balance sheet,
a note about this amount reads: “net of an allowance for doubtful
accounts” of $38 million. This is an important disclosure.

o It makes sense that some customers that owe Intel money may
not pay. In fact, there are very few firms—perhaps none—
that collect all amounts they are owed from their customers.
Therefore, under GAAP, organizations must make an estimate
of how much of the total receivables they are owed that will not
be collected. Intel estimates that it will not collect $38 million
on some $3.6 billion of receivables, a little more than 1%.

o This allowance for doubtful accounts is a subjective estimate.
Presumably, the company has looked at its collection history
and the details of its receivables—who owes what and how

192

long the receivables have been outstanding—to determine
what it believes should be the allowance for doubtful accounts,
but this amount is only an estimate made by management.

o In some cases, management might be motivated to misstate the
allowance for doubtful accounts. For example, if a company
understated this allowance, its reported profits or earnings and
its reported earnings per share would be overstated. Thus, we
need to take a close look at this estimate for all reported periods
to be sure that the figures appear consistent.

• It’s also important to look closely at the change in accounts
receivable from one year to the next.

o Remember that accounts receivable represent sales of products
or services for which the organization has reported the revenue,
income, and earnings but has not yet received the cash.

o Imagine a situation in which a company is very liberal with its
credit terns, allowing customers to take delivery of products
and to make installment payments over an extended period of
time. Obviously, this could create a problem if the customers
ultimately don’t make the payments. In short, accounts
receivable are valuable only if a company collects them!

o Thus, we need to pay close attention to the accounts receivable
balance, changes in the balances over the years presented, and
the allowance for doubtful accounts the company has recorded
as a reserve against those receivables.

• Typically, the last current asset listed on a balance sheet is “Other
assets.” To find out what these other assets are, we generally need to
look at the accompanying footnotes.

Long-Term Assets

• The category “Property, plant, and equipment” usually makes up
the bulk of a company’s longer-term or noncurrent assets. Intel’s
balance of fixed assets is more than $31.4 billion.

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Lecture 26: How to Interpret a Balance Sheet

• The principal issues with respect to any organizations’ fixed assets
are threefold. First, what should be considered a fixed asset—
something that should be reported as an asset on the balance sheet,
as opposed to just accounted for as a normal and recurring expense?
o For example, if you repair a leak in the roof of a building, is

that routine maintenance that should be expensed immediately,
or should it be considered part of the building and recorded
on the balance sheet as an asset? Obviously, there is some
judgment involved here about whether a particular repair really
adds to the useful life of an asset or not.

o However, this simple concept was part of the largest accounting

fraud in history, one perpetrated by MCI WorldCom, in which
the company improperly treated some $10 billion of normal
and recurring expenses as fixed assets on its balance sheet.
The result was a significant overstatement of reported profits
and assets on the balance sheet. The company ultimately filed
for bankruptcy, and its top two executives went to jail for
accounting and shareholder fraud.

• A second question related to an organization’s fixed assets is: How
are they valued on the balance sheet? Is the value based on what the
company paid to purchase them, their worth as of the date of the
balance sheet, or something else?

o All fixed assets are accounted for in a unique manner. They are
recorded on the balance sheet at their original or historical cost,
then depreciated over time. This is true whether the fixed asset
is actually something that depreciates, such as machinery and
equipment, or the company headquarters or other pieces of real
estate that the organization might own, which would generally
be expected to increase in value over time.

o In fact, some organizations own a great deal of real estate,
and because of the depreciation rules, these assets may be
significantly undervalued on their balance sheets.

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• The final consideration regarding fixed assets is how much,
on average, the organization spends each year on fixed assets,
commonly called capital expenditures (CAPEXs). As we’ll see in a
later lecture, CAPEX estimates are important to investors who want
to value companies and stocks.

• Unlike fixed assets, which are clearly tangible, intangible assets
do not have any physical characteristics. These assets include
goodwill, brand names, trademarks, copyrights, and patents.
Generally speaking, organizations report only the intangible assets
they have acquired from another firm, usually as part of merger or
acquisition activity.

Liabilities

• Current liabilities include any amounts the organization expects
to pay within the next 12 months. One quick test to assess an
organization’s liquidity is to check that the balance of current assets
is greater than current liabilities.

• However, in order to better gauge an organization’s risk of
insolvency, we also need to closely examine long-term debt, that
is, the amount the company has borrowed that is due to be repaid
beyond 12 months. Note that we don’t know the exact maturity date
for long-term debt, and this can make a significant difference in the
soundness of an organization’s finances.

o For example, at the end of 2008, American Airlines had about
$8.4 billion of long-term debt, some $6.3 billion of which was
due before the end of 2012—not very long-term. Obviously,
the financial crisis of 2008 hit the airlines hard. American
Airlines could not repay or refinance all its debt and filed for
bankruptcy in late 2011.

o It is imperative to review the footnote in the financial statements
that deals with long-term debt. This footnote will give a clearer
picture about when the long-term debt actually comes due.

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Lecture 26: How to Interpret a Balance Sheet

• Finally, we should note that some debt a company has might not be
listed on the balance sheet at all. The most common example of this
off-balance sheet debt is operating leases. Companies that lease
most of their stores don’t list the value of these long-term leases on
their balance sheets as long-term debt. We’ll revisit this fact later
when we discuss valuation.

Suggested Reading

Collins, Johnson, Mittelstaedt, Revsine, and Soffer, Financial Reporting and
Analysis, chapter 4.

Easton, McAnally, Sommers, and Zhang, Financial Statement Analysis and
Valuation, chapters 2, 5.

Kieso, Weygandt, and Warfield, Intermediate Accounting, chapter 5.

Questions to Consider

1. Using the balance sheet from the company you selected at the end of the
last lecture, determine the amount of total current assets owned by the
company at the end of the most recent fiscal year. How does it compare
to the balance of current liabilities? What is the difference?

2. Again, using that same company balance sheet, what is the total balance
of long-term debt, if any? How has the balance changed from one year
to the next? Finally, review the long-term debt footnote following the
financial statements and determine when the company’s long-term debt
is due. How much is due in the next three years? How much thereafter?

196

Consolidated Balance Sheet: Intel

December 28, 2013 and December 29, 2012

(In Millions, Except Par Value) 2013 2012

Assets

Current assets:

Cash and cash equivalents

5,674

8,478

Short-term investments

5,972

3,999

Accounts receivable, net of allowance for doubtful
accounts of $38 ($38 in 2012)

3,582

3,833

Other current assets

1,649

2,512

Total current assets

32,084

31,358

Property, plant and equipment, net

31,428

27,983

Goodwill

10,513

9,710

Identified intangible assets, net

5,150

6,235

Other long-term assets

5,489

4,148

Total assets

92,358

84,351

Liabilities and stockholders’ equity

Current liabilities:

Short-term debt

281

312

Accounts payable

2,969

3,023

Total current liabilities

13,568

12,898

Long-term debt

13,165

13,136

Stockholders’ equity:

Retained earnings

35,477

32,138

Total stockholders’ equity

58,256

51,203

Total liabilities and stockholders’ equity

92,358

84,351

Source: https://www.sec.gOv/Archives/edgar/data/50863/000005086314000020/al0kdocumentl2282013.htm.

Intel’s consolidated balance sheet combines all of the company’s operations
from around the world.

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Lecture 27: Why the Income Statement Matters

Why the Income Statement Matters

Lecture 27

O f the four basic financial statements, the income statement is the
one most widely followed and cited by the media and investment
community. In fact, if you follow the business news during certain
times of the year, the headlines are dominated by company earnings
announcements that often focus on a few key metrics: revenue, gross margin,
net profits, earnings per diluted share, and international sales. Each of these
metrics is either explicitly disclosed on, or derived from, the company’s
income statement. In this lecture, we’ll find out why both companies and
financial markets consider these metrics to be of paramount importance.

Measuring Income

• The income statement details a company’s revenue, expenses, and
profits during a particular period of time, generally a quarter or
a year. As we have discussed, GAAP requires the use of accrual
accounting in generating income statements. As a result, the
recognition of both revenues and expenses and, therefore, profits
does not necessarily occur when cash is either received or paid out.
Revenues are generally recognized as income when they have been
earned through substantial completion of the activities involved in
the earnings process.

• Put in more simple terms, revenues are considered earned when the
company has essentially done what it promised a customer it would
do and the customer has provided either payment or a promise of
payment—an accounts receivable—to the company. The SEC has
added its own guidance about when it is appropriate for companies
to recognize revenue. According to the SEC, firms may recognize
revenue when:

o Evidence exists of an arrangement between buyer and seller
o The product has been delivered or service rendered

198

o The sales price has been determined or is determinable
o The seller is reasonably sure it will collect the sales price.

• In principle, there are many complexities involved in revenue
recognition. For example, insurance companies and companies
involved in selling subscriptions or licenses may recognize
revenue after cash is received. But in many other cases, revenue
is recognized before cash is received, when a company provides a
product or service to a customer in exchange for payment at some
later time.

• Similarly, expenses can be recognized in different ways and at
different times, depending on circumstances. Generally speaking,
expenses are “matched” with their underlying revenues to provide
as accurate a profit picture as possible. For example, cost of goods
sold (COGS), shipping costs, and commissions should be allocated
or matched to the revenues to which they relate.

o Other expenses can be systematically and rationally allocated
over time. For example, the cost of buildings and equipment
is expensed or depreciated over the estimated period during
which they will be in use. And the cost of patents is amortized
over the period of time the patent lasts.

o Finally, some expenses not tied to specific revenues are
immediately recognized. These include most administrative
costs; salaries; utilities; and selling, marketing, and advertising
expenses. One other example in the United States is research
and development costs, simply because the future benefit
of such expenditures is highly uncertain, and thus, the more
conservative treatment is to expense them immediately.

• The important point here is that revenue and expenses can be
recognized at different times, depending on circumstances, and they
may or may not be closely tied to the actual receipt or payment of
cash. But our discussion so far reveals some important guidelines

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Lecture 27: Why the Income Statement Matters

for accountants: Revenues must be earned and realized; expenses
must be matched with revenues; and when in doubt, be conservative
in recognizing revenue or income.

Organization and Structure of Income Statements

• Broadly speaking, income statements detail two categories
of income: income from continuing operations and irregular,
nonrecurring, or extraordinary income items. Income from
continuing operations includes all revenues and expenses, as well
as all gains and losses arising from the ongoing operations of the
firm. This category generally includes six components:

o Revenues

o COGS

o Operating expenses
o Other income

o Other expenses

o Income taxes.

• The starting point for any income statement is revenue, that is, the
amount of sales generated during the financial reporting period,
reduced by any sales returns or other discounts.

• Next, a typical income statement provides cost of sales or COGS.
Three items make up COGS: direct labor, direct materials, and
manufacturing overhead.

o Direct labor is labor used in the process of manufacturing a
company’s products or, for a service provider, the cost of
personnel directly involved in the delivery of services to
customers. Direct materials are the costs of the raw materials
included in the goods sold. Manufacturing overhead includes

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certain indirect costs that are allocated to the products sold, such
as rent, insurance, and utilities related to the manufacturing
plant where a company’s products are made.

o Subtracting COGS from sales provides the first important and
commonly cited subtotal in income statements: gross profit or
gross margin. The gross profit percentage (gross profit divided
by sales) is a widely cited measure of profitability and allows
for simple comparisons between two years of operations and
between different companies.

• Following gross profit, firms deduct other costs and expenses,
generally known as operating expenses. These include almost all
other costs and expenses not included in COGS, such as selling
and marketing costs, delivery expenses, most depreciation, and
expenditures on research and development. These expenses
generally range from 15% to 20% of revenues, depending on the
particular company or organization.

• The next subtotal on a typical income statement is operating
income, which is the result of deducting the operating expenses
from gross profit. This figure is often referred to as earnings before
interest and tax expense (EBIT) and may be considered the most
significant disclosure on the income statement. EBIT shows the
amount of income or loss an organization actually generates from
its normal and recurring activities.

• Following operating income, an income statement usually discloses
other nonoperating income or expenses, such as interest income
earned on investments or interest expense incurred on outstanding
debt. Often, firms add the interest income and interest expense and
report the net result as a single figure on the income statement.

• The next item on the income statement is income tax expense or the
provision for income taxes.

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Lecture 27: Why the Income Statement Matters

o Note that this expense is not equal to the taxes paid during
the year. Just as companies must use accrual accounting for
all other revenues and expenses, income taxes are based not
only on the current amounts payable but also on the anticipated
future tax implications of current transactions.

o Note, too, that this item captures all of an organization’s
income taxes: federal, state, local, and international.

o Finally, it is possible that income taxes could be a positive
figure, that is, an income tax benefit, as opposed to an expense.

• Once taxes are deducted from the income before taxes, the result
is net income. Although this “bottom line” is certainly important,
it might include one-time income or expenses that are not part
of recurring operating results, which are what we really want to
understand and evaluate.

• The final disclosure on the income statement is earnings per share,
which is the net income divided by the weighted average number
of shares of common stock outstanding during the period. Again,
earnings per share is widely cited as a simple barometer of financial
performance, usually compared to, or benchmarked against, Wall
Street expectations.

o Earnings per share is divided into two categories: basic
and diluted. Basic earnings per share includes the shares of
common stock that are currently issued and outstanding.
Diluted earnings per share tries to capture the estimated
impact of any stock options the company may have issued,
as well as the impact of any securities the company may have
that are potentially convertible into common stock at some
point in the future.

o By definition, diluted earnings per share must be less than or
equal to basic earnings per share. Diluted earnings per share
is the category most closely watched by investors and Wall
Street analysts.

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Key Questions

• There are four key questions we should ask about any income
statement. First, is the company profitable or not?

• Second, what is the company’s gross profit or loss, and how does
the gross profit compare to both the operating income or loss and
the bottom line?

• Third, how do the results compare to the prior period?

• Finally, do the reported results show any consistent and persistent
trends? Because we usually evaluate historical financial results and
accounting disclosures to predict the future, it is important to get a
sense of how consistent past results have been.

EBITDA

• From the numbers on the income statement, we are able to calculate
a significant and common measure known as earnings before
interest, taxes, depreciation, and amortization (EBITDA).

• Why do we need to compute any metrics beyond those that already
appear on the income statement? Remember that the income
statement reflects not only normal and recurring operating expenses
but also the impact of a company’s financing choices.

o For example, what if you were comparing two companies
that had the same sales and operating expenses, but one had
financed its business entirely with debt and the other, solely
with investor equity?

o The one that was funded with debt would show significant
interest expenses and, thus, much lower income before taxes
and lower net income. Should that company be worth less as a
whole than the company funded entirely with stock?

o Just as the value of your home does not depend on the amount
of your mortgage, the answer here is generally no. This is an
important concept that we will return to in a future lecture.

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Lecture 27: Why the Income Statement Matters

For now, we should simply appreciate the fact that a firm is
not worth less as a whole because it has decided to fund its
business differently.

• The other reason EBITDA is widely used is that it is supposed to be
a proxy for the actual cash flows generated by the firm. As a result
of accrual accounting, we cannot simply conclude that a company’s
reported profits tell us much about its actual cash flows. By adding
back interest; income taxes; and certain non-cash expenses, such as
depreciation and amortization, EBITDA provides us with a more
reasonable approximation of a company’s cash flows.

• The basic way to calculate EBITDA is as follows:
EBITDA = Operating income or loss + Depreciation and
amortization expense. Depreciation and amortization expenses are
separately disclosed in the statement of cash flows, which we will
discuss in the next lecture.

Suggested Reading

Collins, Johnson, Mittelstaedt, Revsine, and Soffer, Financial Reporting and
Analysis, chapters 2-3.

Easton, McAnally, Sommers, and Zhang, Financial Statement Analysis and
Valuation, chapters 3, 6-7.

Kieso, Weygandt, and Warfield, Intermediate Accounting, chapters 4, 18.

Questions to Consider

1. Using the 2013 annual report and Form 10-K for Time Warner Cable
(http://ir.timewarnercable.com/files/doc_financials/Annual%20Reports/
twc%20ar%202013.pdf), review the description of how the company
recognizes revenues and costs in each of its businesses and business
units (starting on page 70). Does the description make sense and
seem consistent with the underlying nature of the particular business
and/or transactions?

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2 . Review the 2013 income statement (consolidated statement of
earnings) for Berkshire Hathaway (http://www.berkshirehathaway.
com/2013ar/2013ar.pdf, page 29). How does the company identify its
three business units? Which one reported the most pretax profits in 2013?

Income Statement: Apple Inc.

Twelve Months Ended

September 28,

September 29,

2013

2012

Net sales

$ 107,910

156,508

Cost of sales (1)

106,606

87,846

Gross margin

64,304

68,662

Operating expenses:

Research and development (1)

4,475

3,381

Selling, general and administrative (1)

10,830

10,040

Total operating expenses

15,305

13,421

Operating income

48,999

55,241

Other income/(expense), net

1,156

522

Income before provision for income taxes

50,155

55,763

Provision for income taxes

13,118

14,030

Net income

$ 37.037

41.733

Earnings per share:

Basic

$ 40.03

44.64

Diluted

$ 39.75

44.15

Source: https://www.sec.gov/Archives/edgar/data/320193/000119312513416534/d590790dl0k.htm.

An excerpt from Apple’s income statement shows the typical structure of this
type of disclosure.

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Lecture 28: How to Analyze a Cash Flow Statement

How to Analyze a Cash Flow Statement

Lecture 28

T he statement of cash flows allows us to reconcile accrual accounting
and its impact on reported revenues and profits with actual cash flows.
This statement is important in valuation because the value of any
asset—stocks, bonds, or income-producing real estate—is the current value
of the cash flows that asset is expected to generate in the future. In other
words, the value of a company’s stock today should be the value—in today’s
dollars—of the shareholder-level cash flows the company is expected to earn
over time. Notice that we refer to valuation in the context of cash flows, not
revenues or net income. Although revenues and profits are important, cash
really is king in valuation.

Differences in Revenues, Profits, and Cash Flows

• As you recall, organizations that follow GAAP typically record
revenues on the delivery of the product or service to customers.
Although collectability of any amounts owed must be reasonably
certain, customers may or may not ultimately make good on
amounts they owe if they do not make payment at the time of
the sale.

• For example, imagine that Cisco, the large telecommunications
and networking equipment manufacturer, sells millions of dollars
of equipment to a start-up. As long as Cisco has delivered the
equipment to the customer and the customer promises to pay for
it, Cisco can record the revenues and profits related to that sale,
although the actual cash from the sale will come later. But what if
the start-up goes out of business before it has paid the full amount
it owes to Cisco?

• Most companies require that customers pay their receivables
within 30 to 90 days following a sale. Procter & Gamble, the
multinational consumer products company, collects receivables
from its customers—Walmart, Costco, Target, and so on—

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on average, in about a month. On the other extreme, finance
companies, which make business or home loans, make take years
to collect their receivables.

• In simple economic terms, companies generally report and record
revenues and profits before they collect the cash. If the time lag is
only a few months, that might not be a problem. But what if it takes
longer or the customers ultimately don’t pay? You can imagine how
such companies as Cisco performed during the dot-com bubble in
the late 1990s or how homebuilders and banks performed in the
mid-2000s. Initially, they reported fantastic revenues, profits, and
earnings per share, but ultimately, they took large losses when
customers did not pay as expected.

• In 2010, Green Mountain Coffee reported tremendous growth in
revenues and profits but far lower cash flows. It’s easy to imagine
how this difference occurred: The company sells its coffee
makers to department stores and other retailers, providing liberal
credit terms that allow these customers to pay off the receivables
over an extended period of time. As long as Green Mountain
ultimately expects to get paid, it can record the revenue and the
profits immediately. But there would then be potentially large
discrepancies between these profits and the actual operating cash
flows of the company, at least in the short run.

• In contrast, in 2011, Apple reported cash flows that were higher than
net profits. This difference can be attributed to two considerations:
First, Apple typically receives cash immediately when it sells
its products. Second, because Apple has so many stores, the
company reports a fair amount of depreciation expense, which
reduces reported profits but has no impact on cash flows. Thus,
for companies with high non-cash expenses, actual operating cash
flows can be higher than reported profits.

• For these reasons, in evaluating financial statements, we want to
compare reported accrual-based profits and cash flows, looking for
a close relationship between the two.

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Lecture 28: How to Analyze a Cash Flow Statement

Operating Cash Flow

• Overall, the statement of cash flows lays out both the sources and
the uses of cash during a particular period of time, generally a
quarter or year, the same period covered by the income statement.
The statement of cash flows is divided into three sections: operating,
investing, and financing. The total of those three cash flows yields
the total change in cash for the period.

• The operating section of the cash flow statement discloses the
actual cash either generated or used by the company in the normal,
recurring, and routine course of business. Here, firms start with the
net income reported on their income statements; by making certain
additions and deductions to reconcile the reported income to cash
flows, they then derive the actual operating cash flows.

• As a starting point, firms add back any non-cash expenses they
may have recorded in the income statements, such as depreciation
and amortization expense or compensation expense from stock
options, all of which require no outlay of cash. Then, to the extent
they reported various revenues and/or expenses either greater or
less than the actual cash received or spent, they add or subtract
those differences.

• For example, if a firm sold more product on credit than it collected
in cash, we would see, of course, a net increase in the company’s
accounts receivable on the balance sheet. On the statement of cash
flows, this net increase in receivables would be subtracted from net
income to compute actual operating cash flows.

• The operating section of the statement of cash flows may be the
most important section of a quarterly or annual report because it
allows us to see whether a firm is generating or bleeding cash, it
also shows us how closely cash flows track net income. As we
would expect, most mature companies generate positive cash flows
from operations, while start-up companies, certain technology
companies, and seasonal businesses might not.

208

• As mentioned in the last lecture, EBITDA is a metric that is
widely used in finance and valuation. The most common method
for calculating EBITDA is to start with the operating earnings or
loss from the income statement, then add back depreciation and
amortization expenses, which are disclosed in the statement of
cash flows.

Investing Cash Flow

• The investing section of the statement of cash flows lays out the
cash flows from various nonrecurring, nonoperating activities
of the firm. These may include investments in property, plant, or
equipment; mergers and acquisitions; or investments in stocks
and bonds. Investing cash flows are usually negative, because all
organizations, even those that are losing money, tend to make at
least some investments, even if only to replace outdated computers
and equipment.

All companies need to make some investment in capital expenditures, such as
new property or equipment, to replace obsolete machinery and to grow.

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Digital Vision/Photodisc/Thinkstock.

Lecture 28: How to Analyze a Cash Flow Statement

• The most important figure in this section is capital expenditures—
additions to property, plant, and equipment. All firms need to
reinvest at least some amount of cash into the business to maintain
their current level of operations as machinery wears out and
computers and other equipment become obsolete. Then, companies
need to invest if they intend to grow.

• Thus, the difference between operating cash flows—the cash
generated by or used in normal business operations—and amounts
expended on capital expenditures is often referred to as free cash
flow. That’s the leftover cash that firms can spend on acquisitions,
dividends, stock repurchases, reductions in debt, stocks and bonds,
and so on.

• In fact, free cash flows are arguably the most important link
between accounting and finance, certainly when it comes to the
valuation of stocks.

o When you buy shares of stock in a company, you are basically
purchasing a share of the free cash flows that the company is
expected to generate in the future and that you, as a shareholder,
own a right to or an interest in.

o As mentioned, the historical results of the company are
important, but only inasmuch as they provide information to
help predict or anticipate the future. Therefore, in accounting
and finance terms, we say that the price of any stock should be
the present value of a company’s expected free cash flows to be
earned by shareholders over time.

o Free cash flows represent the cash that a company or
organization is able to generate from its core operations, less
any expenditures it must make to maintain its asset base. Free
cash flow is important because it allows a company to pursue
opportunities that enhance and grow shareholder value.

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• One way to calculate free cash flow is with the “eyeball method”;
here, you simply start with the cash flows from operations and
subtract the capital expenditures. The only shortcoming of this
metric is that it includes interest expense, which is usually ignored
in valuation. In a later lecture, we will look at a more precise
measure of free cash flows that is free from the impacts of leverage
and interest expense.

Financing Cash Flow

• Financing activities include any cash transactions involving an
organization’s debt or borrowings, as well as its equity or stock.
These transactions may include borrowing, that is, issuing bonds
or taking out a loan from a bank; paying back such debt; issuing
or repurchasing stock; or paying dividends. Not surprisingly,
these activities are directly tied to operating and free cash flows.
Companies with significant free cash flows can generally pay down
their debt and pay dividends.

• More than 70% of U.S. companies generate positive cash flows
from operations, and more than 80% generate negative cash flows
from investing activities. However, we cannot generalize about
cash flows from financing activities because even successful
companies with significant free cash flows may issue stock or debt
to fund growth or acquisitions or to take advantage of opportunities
in the market.

Reviewing the Statement of Cash Flows

• In reviewing a company’s statement of cash flows, first, we want
to review the total amount of operating cash flows generated for
the year to look for noticeable trends over recent years. Clearly, we
would like to see positive operating cash flows that are growing
from year to year.

• Second, we want to compare the reported operating cash flows to
net income. If there are large differences, we should investigate
what might be driving them. Is the company not collecting its

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Lecture 28: How to Analyze a Cash Flow Statement

receivables? Does the company have significant non-cash income?
Because the operating section of the statement of cash flows
requires firms to reconcile net income to operating cash flows, we
can generally see what is driving the difference.

• Finally, we want to see what the company actually did with the
money it made. Or if the operating cash flows are negative, we want
to know how the company dealt with that shortfall. Did the firm sell
assets, issue stock, borrow money, or use cash reserves?

Suggested Reading

Collins, Johnson, Mittelstaedt, Revsine, and Soffer, Financial Reporting and
Analysis, chapter 4.

Easton, McAnally, Sommers, and Zhang, Financial Statement Analysis and
Valuation, chapter 2.

Kieso, Weygandt, and Warfield, Intermediate Accounting, chapters 5, 23.

Questions to Consider

1. If an organization’s cash flow from operations is negative, what are the
potential sources of cash for the organization to remain in business?

2. Which industries would you expect to have especially seasonal cash
flows during the year? Examine several cash flow statements for a
company or company in that industry within a given year. Are the cash
flow statements consistent with what you anticipated seeing?

212

Common Size, Trend, and Ratio Analysis

Lecture 29

I n this lecture, we will get an overview of three financial analysis tools:
common size analysis, trend analysis, and ratio analysis. Each of these
tools can be used to analyze a company’s historical performance, to
make comparisons between firms, and to predict future results. And all
of them rely on the financial statements we’ve already discussed: the
income statement, balance sheet, and statement of cash flows. To make our
discussion of the tools concrete, we will use Procter & Gamble (P&G) as our
starting point. P&G is the world’s largest consumer products company, with
nearly $84 billion in sales and 25 different billion-dollar brands, including
such household names as Tide, Crest, Charmin, and Bounty.

Common Size Analysis

• A quick review of P&G’s 2013 income statement shows revenues
of $84.2 billion, operating income of $14.5 billion, and net income
of $11.3 billion. Obviously, P&G is a large and profitable firm, but
how should we evaluate its financial performance? Is the company
growing? Is it doing better or worse than its competitors? We need
some analytical tools to help answer these questions.

• The first tool we need is common size analysis. This analysis
involves converting all the absolute figures on the company’s
financial statements to percentages. By doing this conversion, we
will be better able to compare P&G’s performance over time and to
its competition.

• In a common size income statement, we simply compare all line
items to sales or revenues, setting sales or revenues equal to 100%,
as shown on the following page.

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Lecture 29: Common Size, Trend, and Ratio Analysis

Line Item

Reported
in 2013

Converted
to Percentage

Revenues

$ 84.2 B

100.0%

COGS

$ 42.4 B

50.4%* *

Operating income (operating margin)

$ 14.5 B

17.2%

Net income (net margin)

$ 11.3 B

13.4%

*Subtracting the COGS percentage from the revenue percentage yields a gross profit percentage
(or gross margin) of 49.6%.

• The math is not that complicated, but the results are powerful.
In a few quick steps, we can compute P&G’s 2013 gross margin,
operating margin, and net margin. We can then compare those
figures to prior years and to competitors (as shown below). To
the extent that the results are greater or less than expectations or
budgets, prior year results, or competitors’ figures, management can
perform further analyses and, perhaps, make strategic changes.

Line Item

Gross margin
Operating margin
Net margin

Colgate-

P&G2013 P&G2012 Palmolive 2013

49.6% 49.3% 58.6%

17.2% 15.9% 20.4%

13.4% 12.9% 12.9%

• Common size analysis also tells us about a firm’s operating
leverage. This term refers to an entity’s cost structure and whether
it mostly consists of fixed costs —those that don’t change with
increases in sales volume, such as rent—or variable costs —those
that change proportionately as sales volume increases, such as
sales commissions.

Trend Analysis

• We can gauge operating leverage and performance over time through
trend analysis. Here, we first choose a particular base year and set
every figure in that year’s financial statements equal to 100%. Then,
we look at subsequent years, comparing each line in the financial
statements to the base year (again, converting to percentages) to see
how the financial statement lines are trending.

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• In 2011, P&G reported revenues of $81.1 billion. If we set this
figure equal to 100%, we can then compare the 2012 and 2013
revenues to the 2011 figure and gauge the resulting trends. For
example, P&G reported 2012 and 2013 revenues of $83.7 and
$84.2 billion, respectively. If we divide those revenues by the base
revenue of $81.1 billion, we see that revenues grew by 3.2% from
2011 to 2012, but the recent trend is much lower; 2013 revenues
grew only 3.8% compared to revenues in 2011.

• More troubling, we find that 2012 operating income was less than
86% of 2011 levels. Although 2013 operating income was 93.5% of
2011 levels, the trend was still down over the past couple of years.
And net income shows similar trends. Operating leverage was,
therefore, negative because increases in revenues did not translate
to higher profits.

• You would probably not be surprised to learn that P&G made
substantial changes in 2013, including replacing the company’s
CEO. Sales revenues increased modestly each year, but trend
analysis revealed that the company’s profitability was waning
because costs were growing faster than sales revenue.

Applying Analyses to Other Financial Statements

• The approach to common size and trend analysis for both the
balance sheet and the statement of cash flows is similar to that used
with the income statement. Trend analysis is straightforward: We
select the base year, which should be the same year as that set for
the income statement trend analysis, and compare that year to later
years on the balance sheet or statement of cash flows.

• For common size analysis, we need to choose the denominator, or
the particular line on the balance sheet or cash flow statement that
will be set equal to 100%.

o For the balance sheet common size analysis, we use total assets
as the denominator. Thus, at the end of 2013, P&G reported
total assets of $139.3 billion. We then compare every other
balance sheet line item to this figure, putting the results in

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Lecture 29: Common Size, Trend, and Ratio Analysis

percentage terms. For example, total long-term debt for P&G
in 2013 was $19.1 billion. We divide that number by $139.3
billion and see that long-term debt was 13.7% of total assets.

o To perform a common size analysis for the statement of cash
flows, the typical approach is to compare each of the line
items to total sales revenue, which is drawn from the income
statement. We can also gain interesting insights by comparing
each of the line items to cash flows from operations. For
example, in 2011, P&G’s net income from the statement of
cash flows was $11.9 billion, nearly 90% of the operating cash
flow of $13.3 billion. But in 2013, that same figure declined to
less than 77%. Why?

o It appears that P&G sold some businesses, reporting gains
on the income statement and improving the bottom line but
not improving operating cash flows. However, P&G’s 2013
operating cash flows were $14.9 billion, compared to $13.3
billion in 2011, an increase of about 12%.

Liquidity and Efficiency Ratios

• Like common size and trend analysis, ratio analysis can be used to

analyze many aspects of a company’s financial performance. There

are five categories of ratios to consider:

o Liquidity ratios.

o Profitability ratios.

o Efficiency or activity’ ratios {turnover ratios), which measure
how efficient an organization is in managing its working capital.

o Leverage or solvency ratios, measuring the overall riskiness
of an organization and its ability to service its longer-term
obligations.

o Market ratios, which serve as a link between accounting
disclosures and valuation.

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• The most common ratio to measure organizational liquidity is
to divide the total current assets by the current liabilities at any
balance sheet date. This yields the current ratio. Generally, we
want to see current ratios of at least 1.0, indicating that current
assets at least cover current liabilities. Even better, we’d like to see
current ratios of 2.0, indicating that current assets are at least twice
current liabilities.

• One efficiency ratio is the accounts receivable turnover ratio , which
measures how quickly, on average, a company is able to collect its
receivables from customers.

o The formula for this ratio is sales revenue divided by average
accounts receivable for a defined period. To find the average
accounts receivable, add the balance of receivables (from the
balance sheet) at the start of the period to the balance at the end
of the period and divide that sum by 2.

o Dividing revenues by that average balance reveals how many
times, on average, the company collected its receivables during
the period. We then divide that result into 365 days to see how
long a typical receivable is outstanding before it is collected.

• The inventory turnover ratio measures how quickly a company
turns over or sells its inventory. The formula is similar to that for
the accounts receivable turnover ratio, except that instead of sales
revenue in the numerator, we use COGS, and divide by the average
inventory balance during the period.

• The accounts payable turnover ratio uses the same approach,
dividing COGS by the average accounts payable balance.

Profitability Ratios

• We’ve already encountered some profitability ratios—specifically,
the gross, operating, and net margin percentages derived from
common size analysis. The other set of profitability ratios are return
on investment (ROI) metrics, including return on assets (ROA) and
return on equity (ROE).

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Lecture 29: Common Size, Trend, and Ratio Analysis

• ROA is calculated by dividing a company’s earnings before interest
expense during a certain period by the average total assets the
company has outstanding during that same period. To compute the
numerator—earnings before interest—we start with the reported net
income, add back the interest expense incurred during the period
(adding back any taxes saved from the interest expense), then
divide that result by the average assets, computed as the beginning
total assets and the ending assets, divided by 2.

o ROA is essentially a combination of two elements: profit
margins and asset efficiency.

o If an organization is both profitable and manages its assets
efficiently, ROA is maximized.

• ROE is calculated by dividing net income by average shareholders’
equity. ROE is a combination of three elements: profit margins,
asset efficiency, and leverage—the amount of long-term debt an
organization has.

o It makes sense that a company can improve its ROE by being
more profitable and efficient, but it may not be intuitive that it
can improve ROE by increasing its debt, all else equal.

o Essentially, the cost of debt is cheaper than the cost of equity.
That is, the return that lenders get when we borrow is less than
the return we expect from capital.

Leverage and Market Ratios

• Leverage or solvency ratios are additional measures to determine
the risk associated with a firm and whether it will be able to meet its
longer-term obligations. Leverage ratios include the ratio of a firm’s
long-tenn debt to total assets, shareholders’ equity to total assets,
and operating income to interest expense (interest coverage ratio).

218

• Market ratios allow us to bridge accounting disclosures and market
valuation. A common example is the price-earnings ratio, which is
calculated by dividing a company’s stock price by its earnings per
share. Other examples include the ratio of a company’s total stock
market value to total revenues, known as the price-to-sales ratio.
We’ll return to these ratios in a later lecture.

Suggested Reading

Alvarez and Fridson, Financial Statement Analysis, chapter 13.

Collins, Johnson, Mittelstaedt, Revsine, and Softer, Financial Reporting and
Analysis, chapter 5.

Questions to Consider

1. In the last several years, interest rates have declined significantly,
causing firms to borrow significant sums in the form of bond issuances
and bank loans. Many times, firms use these funds to repurchase shares
of stock. How would these transactions increase a firm’s leverage and
return on equity ratios, and why?

2. Warehouse clubs, such as Costco, Sam’s Club, and BJ’s Wholesale
Club, and even certain large retailers, such as Walmart, have current
ratios of less than 1.0. Explain how this can occur.

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Lecture 30: Cost-Volume-Profit Analysis

Cost-Volume-Profit Analysis

Lecture 30

B reakeven analysis is a managerial accounting tool with widespread
application. Whenever a firm is considering introducing a product
or offering a new service, managers must ask: How many units of
the product do we need to sell or how many client hours do we need to bill
to break even? Breakeven analysis is more formally known as cost-volume-
profit analysis because the goal of any business is not just to break even,
of course, but to generate enough profit on the capital investment required
to produce, market, and distribute the new brand or offer the new service,
given the costs involved. Therefore, once we introduce the basic breakeven
model, we will complicate it so that it can be used to provide profit forecasts,
assistance in budgeting, and answers to many “what-if ’ questions.

Types of Costs

• The first step in cost-volume-profit analysis is to restate the
traditional financial accounting profit formula. As you recall, this
formula starts with sales, then deducts COGS, various operating
expenses, and income taxes in order to compute net income or loss,
o In cost-volume-profit analysis, we also start with revenues,
but instead of lumping all expenses together as selling,
general, or administrative, we break down all expenses into
two categories: fixed or variable. Remember that traditional
financial accounting is concerned only with whether
an expense is operating—related to core and recurring
operations—or not. In managerial accounting, however, we
want to know how a particular cost or expense behaves over
changing levels of activity.

o Fixed costs, such as rent or insurance, remain the same
regardless of how well or poorly a firm is doing. In contrast,
variable costs, such as sales commissions, vary directly with
the volume of business the firm generates.

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o Mixed or semi-variable costs are a combination of these
two. Most utilities, for example, have a fixed component, a
minimum amount we have to pay each month, and an amount
on top of the minimum based on the actual electricity, gas, or
water used. In such cases, the fixed portion of the costs can be
separated from the variable portion.

o Finally, it’s important to note that all costs vary in the long
run. For example, if your business is doing well and expanding
rapidly, you may need to open a second location in order to
increase capacity, which would add a layer of additional fixed
costs. Thus, we can think of costs as being fixed over some
level of volume or activity, then jumping up to another level of
fixed costs, and so on.

• The important point here is that if you want to make key business
decisions, you need to understand and distinguish among the types
of costs your business incurs. Traditional financial accounting
categories, such as selling, general, and administrative expenses or
research and development costs, are simply inadequate for this task.

Managerial Accounting Profit Formula

• To restate the basic profit formula in managerial terms, we start
with revenues, then subtract total variable costs, followed by total
fixed costs to derive profit or loss:

Revenues - Total variable costs - Total fixed costs = Profit
or loss

• The next step is to break this formula down into smaller
components, so that we can compute the breakeven point and run
numerous what-if scenarios.

o Revenues are made up of two components: the average selling
price for the products or services multiplied by the volume
of products or services sold—basically, price multiplied
by quantity.

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Lecture 30: Cost-Volume-Profit Analysis

o Similarly, the total variable costs also have two components:
the quantity of product or services sold multiplied by the
average variable costs incurred in each transaction.

o Fixed costs are a constant.

• We now have a more detailed equation: Revenue, broken down by
sales volume and average sales prices, minus total variable costs,
also broken down by average variable costs and volume, minus the
fixed costs constant. Note that one of the variables in both revenues
and total variable costs is sales volume—the number of units sold.

• Because our initial objective is to solve for the breakeven point, we
will set this entire equation equal to zero. Therefore, the breakeven
formula is:

(Average sales price per unit x Number of units sold) -
(Average variable costs per unit x Number of units sold) -
Fixed costs = 0

• We then solve for the breakeven quantity, as follows:

Breakeven quantity = Total fixed costs during the period/
(Average sales price per unit - Average variable cost per unit)

Unit Contribution Margin

• The denominator in the breakeven formula—average sales price
minus average variable cost—is known as the unit contribution
margin. Contribution margin helps business owners and managers
not only with budgeting and forecasting but also in making sales,
marketing, and pricing decisions, providing data on the incremental
contributions that every sale makes.

o Imagine that you own a Subway sandwich shop and you’re
considering opening a new location. You estimate that the
total fixed overhead each month, consisting of rent, insurance,
utilities, and so forth, is $25,000. You further assume that the

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average customer spends $8.00 per visit and that the average
variable costs for that meal are $3.00, consisting principally of
food costs and royalties.

o If you plug these assumptions into the breakeven formula,
you get $25,000 divided by a unit contribution margin of
$5.00 ($8.00 - $3.00). Doing the math, you find that the
breakeven number of customers is 5,000. You could then
analyze whether you expect enough traffic to generate that
much business each month.

o Note that in this example, each customer visit and meal sold
contributes $5.00, on average, to cover the fixed costs of the
business. The starting point and initial objective of the business
is to sell enough sandwiches—to generate enough customer
visits—to break even. After that, the objective is to generate a
return above breakeven, enough to compensate for the risk and
capital invested in the business.

• What other decision-making implications does the contribution
margin concept have? Imagine that you own a hotel, and one
night, you have some available rooms. A traveler walks in, asks
the price of a room, and then asks if you can reduce the price.
Should you negotiate?

o As the proprietor, you know the variable costs of providing the
room for the night—principally, housekeeping, linen cleaning,
utilities, and toiletries. In theory, if you charge anything above
those variable costs, then the difference contributes to cover
the fixed costs of the hotel, which tend to be very high. Another
way of thinking about this question is that the opportunity cost
of having a hotel room sit empty is significant.

o Therefore, the concept of contribution margin has special
significance to those businesses with high operating leverages,
such as airlines, hotels, and universities. Think about the
contribution margin of each ticket sold on an airplane. The

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Lecture 30: Cost-Volume-Profit Analysis

Recent bankruptcies in the airline industry reflect the economic realities of high
fixed-cost businesses during tough economic times.

incremental or variable costs associated with this additional
traveler are relatively minor compared to the price of a
ticket, but the consequences of serving an extra traveler are
meaningful. The revenue generated contributes substantially to
the high fixed costs and falls right to the bottom line.

o Unfortunately, the flipside is also true. The opportunity cost
of an unsold seat is very high. The profits of businesses
that have high fixed costs tend to be volatile and cyclical,
moving up or down sharply along with changes in underlying
economic conditions.

224

• The contribution margin concept can also help a business that
produces different products decide which one to promote or
emphasize if production capacity is constrained. The answer in this
case would be the product with the highest contribution margin
because for any level of capacity, maximizing contribution margin
maximizes profits. In other words, for any level of fixed costs, if
you maximize the difference between revenues and variable costs,
you maximize profit.

Solving for Target Profit

• Obviously, the goal of any business is not to break even but to
generate a profit or surplus. How can we use the basic breakeven
formula to solve for a target level of profit? Let’s say that a company
sets a particular target profit, perhaps because of demands from
shareholders, owners, or Wall Street. Then, the breakeven question
is reoriented. How many units does the company need to sell or
how many hours does it need to bill to achieve the target profit?

• To answer that question, we need to tweak the breakeven formula.
We need to add the after-tax target amount of profit we wish to
generate, after converting it to a pretax figure, and instead of
computing for the breakeven point, we calculate the target level of
volume needed to achieve the desired results.

• For example, if we assume that the target profit is $490,000 after
taxes and the total tax rate is expected to be 30%, we first need to
convert the after-tax profit target to a pretax figure. Then, we simply
add this result to the fixed costs in the breakeven formula.

o For example, if the promoter of a Rolling Stones concert wants
to generate an after-tax profit of $490,000 and has a tax rate
of 30%, the concert will need to generate $700,000 of pretax
profits. To derive this result, we simply divide the after-tax
profit target of $490,000 by 1 - 30% (the tax rate), or 0.7:
$490,000/0.7 = $700,000.

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Lecture 30: Cost-Volume-Profit Analysis

o Once we have the pretax profit computed, we simply add it to
the fixed costs and recompute the breakeven point, although
now it is not a breakeven point but a target volume.

o Recall the breakeven formula:

Breakeven quantity = Total fixed costs during the period/
(Average sales price per unit - Average variable cost
per unit)

The original fixed costs of the concert were $2 million; to
that, we add $700,000 to get a numerator of $2,700,000. If we
assume an average ticket price of $350 and subtract the average
variable costs per ticket of $20, we get a denominator, or unit
contribution margin, of $330. Next, we divide $2,700,000 by
$330, which tells us that the number of tickets we need to sell
to generate the target profit is 8,182.

• Up to this point, we have computed the overall volume needed to
either break even or generate a target pretax profit, but we have not
considered how this translates into sales of individual products or
services for firms that sell more than one thing,
o For example, in our Rolling Stones example, we computed the
target ticket sales at about 8,200 fans, but we know that concert
venues have different types of seats for which they charge
different prices.

o Thus, it’s important to keep in mind that when we are
computing the breakeven point or the target volume, we are
taking a weighted-average contribution margin.

Suggested Reading

Cafferky and Wentworth, Breakeven Analysis.
Eldenburg and Wolcott, Cost Management, chapter 3.

226

Questions to Consider

1. Consider two industries with high operating leverage, characterized
by especially high fixed costs. How do you expect these industries to
perform during economic recessions? Why?

2. In the last few years, airlines have begun to charge coach passengers for
just about everything, including checked bags, food, and headphones.
How does this policy affect the airlines’ contribution margin and
breakeven points, respectively?

227

Lecture 31: Understanding the Time Value of Money

Understanding the Time Value of Money

Lecture 31

O ver the past six lectures, we’ve explored several essential topics in
the field of accounting. With that foundation laid, we’ll now move
into the finance lectures, starting with perhaps the most important
concept in finance: the time value of money. This concept has broad
applications across an array of financial decisions, such as what investments
we should consider; how much a stock, bond, or piece of real estate might
be worth; when we should retire; or whether a municipality should offer
tax incentives to businesses to relocate. In fact, not a single financial or
investment decision does not involve the basic ideas behind the time value of
money principles we will discuss in this lecture.

A Dollar Today versus a Dollar Tomorrow

• Most of us have an intuitive sense that a dollar in our pockets today
is worth more than that same dollar tomorrow. The primary reason
this is true is that we are able to invest money we have today and earn
some return on it. And we all prefer current consumption over future
consumption, all else equal; thus, we must be compensated in some
way to give up current consumption for something in the future.

• The other way to think about this basic concept is related to
inflation; price increases mean that we can purchase less in the
future with the same money we have today. Again, most of us can
intuitively understand that in the event of higher inflation, the value
of money in our pockets decreases.

• We also have to consider risk: Future cash flows involve the risk that
for some reason or another, we might not get the cash we expect.

• For all these reasons, time most definitely is money, but the question
is: Flow much? Flow much more is your money worth today versus
tomorrow or next year or 10 years from now? To answer that
question, we need to introduce two related terms: discounting and

228

discount rate. Discounting is the process by which future cash flows
are adjusted to some equivalent amount today. The discount rate is
the interest rate used to capture inflation, risk, and our preference
for current consumption over future consumption.

Compounding

• Let’s start with a relatively simple example to highlight some
mechanics of the time value of money. Assume you invest $ 100 today
and earn 4% each year on that investment after taxes. By the end of
the first year, you’11 have $104. At the end of the second year, you’11
have $108.16, and at the end of the third year, you’ll have $112. 49.

• This example represents the relatively simply but powerful
concept of compounding , the idea that you earn returns not just
on your original investment but on any return that investment has
previously generated. It may not seem like much, but over a longer-
term investment horizon, the additional money can add up.

• Without question, compounding is a critical component of the time
value of money, but it also has a flipside. Let’s say you plan to keep
$100 under your mattress. Let’s also assume that inflation is 4% a
year. In this scenario, you lose significant purchasing power after two
years because your $100 cannot buy the same amount of groceries
or gas that it could previously. In addition, your loss of purchasing
power compounds over time. Each year you can afford less.

• At this point, let’s introduce two more important terms in finance:
present value and future value. Present value represents the value
of a future cash flow we expect to receive in today’s dollars. That
is, if you expect to receive $100 in three years, how much is that
worth today? Future value is essentially the opposite; it represents
the value in the future of some amount invested today.

• In our previous example, we would say that the future value of $ 100
invested for two years at 4% compounded annually is $108.16.
Conversely, we would say that the present value of $108.16
received in two years at a discount rate of 4% is $100.

229

Lecture 31: Understanding the Time Value of Money

230

Cash Flows

There are five types of cash flows we need to discuss to link the
time value of money concept to real-world finance and investment
examples: single cash flows or lump sums, annuities, growing
annuities, perpetuities, and growing perpetuities. We’ll start with
single cash flows.

A single cash flow represents a specific and fixed amount of cash
that will be received or paid in the future, perhaps a lump sum
payment from a retirement plan or the cash expected from the future
sale of a home. We can discount those expected future cash flows to
the present using a discount rate that reflects the uncertainty of the
cash flow.

The present value of a single future cash flow is calculated as
follows:

The lump sum of cash at some specific time in the future is denoted
by CF, the discount rate is denoted by i, and the number of years
in the future when the lump sum is expected to be received is
denoted by t.

Suppose you expect to receive $500,000 from the sale of your
house in 15 years, and assume that the discount rate is 7%. If we
plug the numbers into the formula, we get:

That is, receiving $500,000 in 15 years at a discount rate of 7%
is the same thing as receiving $181,223 today. In other words,
$181,223 is the present value of that future cash flow.

230

• Note that the further out t is—the longer you have to wait to receive
the cash—the less valuable the payment is in present-value tenns.
Also notice that as the discount rate increases, the present value of
future cash flows decreases. That makes sense because if inflation is
higher, the value of your money decreases.

o But the discount rate must also capture the riskiness of future
cash flows. In other words, higher-risk investments with
more uncertain cash flows must be discounted at a higher
rate. That means we should be willing to pay less for those
investments today.

o For example, a $500,000 payment to be received in 15 years
is about $321,000 at a 3% discount rate and less than $62,000
at a 15% discount rate. As the discount rate increases and
everything else stays the same, the present value of the money
drops considerably.

Annuities

• An annuity is a constant cash flow that occurs at regular intervals
during a fixed period of time. For example, payouts from retirement
plans or insurance policies are routinely structured as annuities.

• The present value of an annuity can be calculated by taking each
individual future cash flow, discounting it back to the present
through the present-value formula, then adding up all the individual
present values. Another method is to multiply the amount of the
annuity payment or receipt by a formula that captures the sum of
all the individual present values. This annuity factor formula is
shown below:

Present value of annuity

Amount of annuity x

231

Lecture 31: Understanding the Time Value of Money

• This formula can be used in several real-world applications. For
example, let’s compute the monthly mortgage payment on a 30-
year loan of $300,000, with an interest rate of 4.5%.
o The present value of the mortgage is the amount you plan to
borrow: $300,000. The monthly interest rate is 4.5% divided
by 12, or 0.375%, and the total number of payments is 360.

o If we substitute the variables into the annuity equation, we find
that the monthly payment will be a little more than $1,520.

• We can also modify the annuity present-value formula fairly easily
to compute the future value of an annuity. This formula is useful for
estimating how much money you’ll have at retirement if you save
consistently over time. The formula is:

Future value of annuity = Amount of annuity x

Growing Annuities

• A growing annuity is an investment that provides growing cash
flows or returns over time, rather than returns that remain constant.

• Imagine a hospital considering an investment in a new and
expensive surgical robot. This equipment requires an upfront
investment of some $2 to $3 million; thus, any hospital purchasing
one would expect its investment to generate significant and
presumably increasing cash flows over the robot’s expected
useful life.

• Let’s assume that one surgical robot could perform 400 procedures
each year, generating $500,000 in expected profits in its first year of
use. Let’s further assume that this profit is expected to grow by 5%
each year because the prices charged for various surgical procedures
inevitably increase and more doctors use them. Finally, assume that
the robot will last five years before it must be replaced.

232

Under these assumptions, what is the present value of this growing
annuity? The growing annuity factor formula is shown below:

Present value of a growing annuity =

[Annuity x (1 + g)] x

t 0+gy
(i+O'
U-g)

The fomiula looks fairly complex, but it has just four
variables: (1) the amount of the initial annuity, here, $500,000;

(2) the expected growth rate in the annuity, g, here, 5%;

(3) the amount of time the annuity will last, t, here, 5 years; and

(4) the discount rate, i, assumed here to be 10%. If we plug in
the numbers, we get:

Present value of a growing annuity :

[$500,000 x (1 +0.05)] x

(1 + .05) 5
(1 + - 1) 5

(0.1-0.05)

• Given our assumptions, the present value of this growing annuity
is $2,179,060. Note that as long as the robot costs less than the
present value of the expected future cash flows, the hospital should
make the investment.

Perpetuities and Growing Perpetuities

• A perpetuity is an annuity of a constant cash flow—inflow or
outflow—that lasts forever. One example is a type of bond first
issued by the British government in the 18 th century known as a
consol bond. By definition, these bonds never mature; since 1923,
they have yielded only 2.5%, but they will pay interest to their
owners forever.

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Lecture 31: Understanding the Time Value of Money

o The present value of a perpetuity is a relatively simple formula:

_ , . Amount of constant annuity

Present value ot perpetuity = -—

o For a consol bond with a face value of $1,000, paying 2.5%
interest once a year, and a discount rate of 6%, the present
value would be $416.67.

• A growing perpetuity is a cash flow that is expected to grow at a
constant rate forever. It is often used to help value stocks for certain
companies, such as IBM or Disney, that are likely to be in business
indefinitely and should grow at a fairly constant rate over time,
o The present value of a growing perpetuity can be calculated
by dividing the amount of the perpetuity expected next year,
denoted as CF V by the difference between the discount rate
and the growth rate:

A piece of real estate that is likely to stay fully leased in perpetuity, such as an
office building in Manhattan, is an example of a growing perpetuity.

234

o Imagine that an apartment building near the UCLA campus
has current cash flows (the difference between all rents and all
expenses) equal to $100,000. These cash flows are expected to
grow 5% each year in perpetuity, and the discount rate for such
an asset is 8%.

o We start by computing next year’s expected cash flows,
which in this case would be $105,000: the $100,000 currently
being earned plus the 5% growth rate. We then divide by the
difference between the discount rate of 8% and the 5% growth
rate: $105,000/3%. The result is $3.5 million, which is the
present value of this stable, well-located apartment asset.

Suggested Reading

Berk and DeMarzo, Corporate Finance, chapter 4.

Brealey, Myers, and Allen, Principles of Corporate Finance, chapter 2.
Kieso, Weygandt, and Warfield, Intermediate Accounting, chapter 6.

Questions to Consider

1. As interest rates decline, stock and bond prices generally increase. Why?

2 . Someone leaves you an odd inheritance, promising to pay your and your
heirs $100 each year until the end of time. How much would such a
perpetuity be worth in today’s dollars?

235

Lecture 32: The Trade-Off between Risk and Return

The Trade-Off between Risk and Return

Lecture 32

A ny asset’s expected return is based on historical returns, which
provide some basis for predicting likely future results, at least over
extended periods of time. But it’s also true that actual results may
vary, certainly over shorter investment periods. In addition, although we
may expect to earn higher returns with higher risk, we cannot and should not
expect to be compensated with additional returns for that portion of risk that
is stock-specific and can be diversified away. In this lecture, we’ll look at the
capital asset pricing model (CAPM), which provides a powerful means of
formally unifying an asset’s expected return and risk, defining risk primarily
in terms of how an asset fluctuates in comparison to the overall markets.

Historical Asset Performance Data

• When we pursue investment opportunities, whether they are
stocks, bonds, real estate, or alternative investments, we should
have some idea of the returns we expect to receive. Generally,
these expectations are based on history—how these assets have
performed and the returns they have generated in the past.

• For some assets, we have good historical performance data. For
others, the historical data are less robust. For example, we have
extensive data on returns from the equity and bond markets over an
extended period of time. (See below.)

Equity and Bond Market Returns, 1926-2013

Average Standard Deviation

Asset Class

Annual Return

of Returns

Large-cap domestic stocks

12.1%

20.2%

Small-cap domestic stocks

16.9%

32.3%

Long-term corporate bonds

6.3%

8.4%

Long-term U.S. government bonds

5.9%

9.8%

U.S. treasury bills

3.5%

3.1%

Inflation

3.0%

4.1%

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• Over time, stocks significantly outperform bonds, and both
significantly outperform inflation. However, within each category
of investment, the more risk that’s involved, the greater the return.
For example, small stocks have earned, on average, 16.9% each
year since 1926. Compare this to the 12.1% return that larger
companies have earned.

• The reason we consider long-term rates of return is that the short
term can be volatile. If we look at results over longer time periods,
short-term blips should be evened out.

• Volatility in asset prices is measured statistically by the standard
deviation of historical returns—how much a particular year’s return
varies in relation to long-term averages. Again, if we look at the
historical data for stocks and bonds, we see that small-cap stocks
have earned an average of 16.9% per year since 1926. However,
their standard deviation is over 32%, substantially higher than any
other category of investment.

• The important point to remember here is that asset and portfolio
returns are based on expectations, and those expectations, in turn,
should be based on long-term historical observations.

Diversifiable Risk

• Although higher expected returns are positively correlated with
higher risk, the fact that you assume greater risk in an investment
does not necessarily mean that you will be compensated for it in
terns of higher expected returns.

• The data on historical returns for stocks and bonds show that
over the past 90 years, large-capitalization stocks had an average
annual return of 12.1%. But that’s a measure for entire portfolios
of securities. Suppose that you invested all your money in only
one successful large-cap company, such as General Electric or
Apple. Should you expect to earn 12.1% on your investment? The
answer is no.

237

Lecture 32: The Trade-Off between Risk and Return

• It makes common sense that if you put all your eggs in one basket,
you are assuming a tremendous amount of very specific risk—the
risk that one company will do very well or very poorly. And any
single company will experience long periods of time when it either
significantly outperforms or significantly underperforms the market.

• This sort of company-level risk is often called diversifiable risk.

o Imagine that instead of putting all of your money in Apple
stock, you put only half in Apple and the other half in General
Electric. With this strategy, you have reduced, at least in part,
your investment risk. But you have not reduced the overall
expected return of your portfolio if historical returns for large-
capitalization stocks prove accurate in the future.

o The significance of this seemingly straightforward point
cannot be overstated. You can diversify away specific risk—
the risk that any one company will perform particularly well
or particularly poorly. This is opposed to market or systematic
risk, which affects all stocks and all companies and is related
to such factors as interest rates, employment levels, and
tax policy.

o Thus, when many stocks—at least 25 to 30 in different
industries—are combined in a single portfolio, the firm-
specific risks for each stock are averaged out and diversified
away. Your portfolio will still be subject to market risk—the
risk that the overall market might go down—but the impact of
any one stock will be tempered by the influence of other stocks
in your portfolio.

• Because volatility can be reduced fairly easily by adding different
stocks to a portfolio, investors should not expect to be compensated
with additional returns for that portion of volatility that is stock-
or company-specific. Investors should expect to be compensated
only for the risks that cannot be diversified away—systematic or
market risk.

238

Beta

• Bela (fi) measures how a particular security has historically co¬
varied with the overall market, usually measured by a broad-based
stock index, such as the S&P 500 or Russell 2000.

o Imagine that over an extended period of time, the stock market
goes up or down by a particular amount while a particular stock
goes up or down, on average, by half that amount. That is, if
the stock market goes up by 1% on any one day, this particular
company’s stock goes up by 0.5%. That stock is then said to
have a f} = 0.5.

o Or imagine a more volatile stock; when the market goes up or
down by x, this stock varies by double that amount. It has a

P = 2 - '

o Of course, if you own an equal share of all stocks in the market,
your expected return would be that of the overall market, and
your portfolio would have a /? = 1.

• Beta is a useful and powerful tool because it allows us to think
about how individual assets are expected to move in relation to
the overall market, which can help us craft an appropriately
diversified portfolio. Beta also helps us understand the risks that
are associated with any individual company. Given what we know
about the historical returns of the overall market, we can estimate
the future returns associated with individual stocks within a
diversified portfolio.

Capital Asset Pricing Model

• Quantifying the relationship between historical and future returns
was a tremendous advance in finance and modern portfolio theory
and led to an extremely important model in finance, the capital asset
pricing model (CAPM).

• To develop an intuition for CAPM, let’s imagine three securities.

239

Lecture 32: The Trade-Off between Risk and Return

o The first has no volatility at all; there is no relationship between
the way this security moves and the overall performance of
the market. This investment might represent, for example, the
money in an insured bank account. Clearly, the return on such
an investment has nothing to do with how the stock market
performs. We would therefore say that this security has a /? = 0
and an expected return of the risk-free rate. That return will be
fairly low, but such is the trade-off for assuming such low risk.

o The second security moves in perfect lockstep with the market.
It has a p = 1, and its expected return would equal that of the
overall market.

o The third security moves up or down at a rate twice that of the
overall market, which means it has a [i = 2. We would expect
this security to earn returns superior to those of the overall
market to compensate us for taking on the additional risk of a
significant loss on our investment.

• If we put these three data points into a mathematical formula, the
result is CAPM, which concludes that the expected return of any
investment in a well-diversified portfolio is equal to: Risk-free
rate + /^(Expected market return - Risk-free rate).

• Essentially, CAPM says that any asset should be expected to earn,
at a minimum, the risk-free rate and some premium for assuming
additional risk. This additional risk is made up of two factors: the
asset’s beta and the equity risk premium, which is the amount that
the overall market is expected to earn above the risk-free rate.

o If you put a certain amount of money into a diversified portfolio
of, say, 30 stocks in different industries, you know that this
portfolio, although diversified, is still more risky than owning
a risk-free U.S. treasury bond. And you should expect to be
compensated for taking on that additional risk. Again, you may
or may not receive that compensation because there is still
some market risk in such a portfolio, but you should expect to
earn some premium. This is known as the equity risk premium.

240

o Academics have debated the amount of the equity risk
premium, but today, most experts agree that it is between
5% and 6%. That is, if you invest in a portfolio of diversified
stocks, you should expect to earn the risk-free rate, plus 5%
or 6%.

• Assume you are considering adding a stock with a /? = 2.0 to your
already diversified portfolio. If the interest rate on 10-year U.S.
treasury bonds is about 2.50% and the equity risk premium is 5.0%,
you would calculate the expected return from this stock as follows:
2.5% + 2(5%) = 12.5%.

Using CAPM

• There are two broad types of investing: active and passive. Passive
investors try to match the market, not beat it, while active investors
try to “beat the market” by picking winners. With CAPM, we can
examine an active fund manager’s portfolio; determine the risk that
he or she took, as measured by beta; and use that beta to predict
how the manager should have done relative to the market.

• Let’s say that a particular fund manager’s portfolio had a weighted
average beta of 1.20 during a particular year.

o We would expect this fund to move by 20% more than the
overall market in either direction. That is, if the overall stock
market went up by 10% during the year, we would expect this
fund to have gone up by 12%.

o If the fund manager’s portfolio went up by 15%, we would
conclude that this manager added additional value from his
or her selection of stocks—an additional 3%. That additional
value is called alpha.

• In recent years, a great deal of research has gone into the predictive
ability of CAPM. When actually realized returns are compared to
what CAPM would have predicted, we find that the model is able
to account for about 85% to 90% of the price movements that
historical betas would have anticipated. Academics in finance and

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Lecture 32: The Trade-Off between Risk and Return

economics have also spent considerable time trying to refine CAPM
and improve its predictive abilities by adding variables and testing
whether they add to the model’s predictive power,
o Perhaps the most well-known of these models is the Fama and
French three-factor model. In addition to the beta factor, the
renowned researchers Eugene Fama and Ken French found two
more factors that improved CAPM’s predictive capabilities: a
stock’s value and the size of the company.

o Value is determined by comparing a company’s shareholders’
equity to its market capitalization, essentially the company’s
value on the stock market. The size of the company is
represented by its market capitalization.

o For example, if a stock has a book value or shareholders’ equity
of $1 billion and a market capitalization of $500 million, it
would appear to be a good value; a buyer is paying a discount
for the company’s reported net assets.

o Fama and French determined that there was a positive
relationship between expected returns and this value factor.
This seems intuitive: If you are buying a stock at what appears
to be a discounted price, you should in turn expect a higher
return. And the opposite is also true. If the stock market is
valuing a company at multiples of what it is reporting as
assets on its balance sheet, it appears that you are buying in
at a premium; therefore, your expected return looking forward
should be lower.

Suggested Reading

Brealey, Myers, and Allen, Principles of Corporate Finance, chapters 7-8.

Easton, McAnally, Sommers, and Zhang, Financial Statement Analysis and
Valuation, chapter 12.

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Questions to Consider

1. Most financial advisors recommend that younger individuals put most, if
not all, of their retirement assets into stocks, then reduce their exposure
to stocks as they near retirement. Why?

2. Assume that the risk-free rate, the yield on 10-year treasury bonds, is
3.0%, and you invest some of your well-diversified stock portfolio into a
company with a beta of 1.15. Assuming that the equity risk premium—
the amount by which the stock market is expected to outperform
risk-free rates—is 5.0%, what is the return you anticipate from this
investment, according to CAPM?

243

Lecture 33: How Investors Use Net Present Value

How Investors Use Net Present Value

Lecture 33

I n this lecture, we will discuss several approaches used for evaluating
investment opportunities: the payback method, the accounting or book
rate of return, and net present value (NPV). Along with CAPM, which we
introduced in the last lecture, NPV may be the most important mathematical
formula in finance. It combines several of the concepts we have discussed
thus far, including the time value of money, expected rates of return, and
risk. As we’ll see, NPV integrates these ideas into a powerful investment
decision-making tool with widespread applications.

Structure of Investment Opportunities

• All investment opportunities are essentially structured in the same
way: An upfront investment is made today in anticipation of some
uncertain cash flows or returns in the future. This is true of a firm
making a capital budgeting decision, a charitable organization
deciding how to spend its limited resources, or an individual
investor deciding whether to purchase a particular stock

• To make smart and value-creating investment decisions, the
future returns or cash flows, which are worth less than the dollars
expended today, must exceed the amount invested. That is, the
present value of the projected future inflows must be greater than
the present value of the outflows. This is essentially the definition
of net present value (NPV).

Payback Method

• Before we delve further into NPV, let’s start with a common
approach to investment decision making: the payback method. This
approach essentially answers the following question: If you make
an investment of %X today, how long do you have to wait until you
recoup your investment?

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• For example, if you invest $10,000 and you expect the investment
to return $1,000 each year after taxes, the payback period would be
10 years. A $100,000 investment that returns $20,000 each year, on
average, would have a five-year payback. All else equal, the shorter
the payback period, the better the investment opportunity. Some
firms establish maximum allowable payback periods against which
investments should be compared.

• The payback approach is widely used for several reasons. It is fairly
simple, easy to apply, and relatively intuitive. We all understand
that if we invest in something, a payback within a few years would
generally make sense.

• However, there are also some serious deficiencies to the payback
approach. After all, the goal of any investment is not just to get
your money back but to make a profit. The payback method ignores
cash flows after the payback period and ignores the time value
of money. Moreover, the maximum acceptable payback period is
usually arbitrary, reflecting some policy decision established in the
past. Thus, the payback method is not an effective way to assess
investment opportunities.

Accounting or Book Rate of Return

• Another method for evaluating investment opportunities is known
as the accounting or book rate of return. As we’ve discussed, when
companies report to shareholders, much of the focus is on the
income statement, especially revenues, net income, and earnings
per share. Cash flows, although certainly important, are usually
not given as much emphasis in quarterly and annual earnings
releases. As a result, some financial managers might use book
accounting data to assess and evaluate investment opportunities,
instead of cash flows, contrary to what finance theory tells us they
should be doing.

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Lecture 33: How Investors Use Net Present Value

• For example, imagine a company operating at capacity that is
considering a $10 million investment in new machinery that
would increase productivity and create value for the company
and its shareholders. The current machinery, although outdated, is
still functional and in use, but it has been fully depreciated and,
therefore, has no value on the company’s balance sheet. If the CFO
were strictly looking at an accounting ROI, any return that the old
machines produce would appear to be infinite. That is, the income
generated by the machines would be made on something with no
accounting value—the depreciated machines. Any positive income
divided by zero will look great.

• Flowever, this is a flawed approach because it is based on financial
accounting metrics, which include non-cash depreciation expense.
This has caused a significant difference between the accounting
value of the equipment under GAAP and its true economic value,
which should be based on actual cash flows and true market values.
Therefore, it is imperative that we look at cash flows, not financial
accounting metrics, to determine whether an investment might be
value-creating.

NPV Formula

• A more robust, reliable, and effective means of evaluating
investment opportunities than the payback or accounting rate of
return approaches is NPV. The NPV is the sum of all the individual
outflows and/or inflows related to any investment, with each of the
individual cash flows discounted to its present value.

• Recall that in order to put future cash flows into today’s dollars, we
must discount them, which requires three inputs: (1) the amount of
the cash flow, (2) the relevant interest or discount rate, and (3) the
time period over which the discounting is to take place. Also recall
the basic present-value formula for an individual lump sum:

246

As an example, suppose that you expect to receive $100 two years
from today at a discount rate of 5%. What’s the present value of that
$100? Plugging in the numbers, we get:

$i°o =$9070

(1.05)

• We then plug the present value of future cash flows into the NPV
formula:

NPV = Present value of future cash flows ( CF ) - Initial
investment required (CFj

NPV = —CF 0 +

CF,

Assessing an Investment

• Let’s walk through an example together. Assume that a small
regional hospital is considering three mutually exclusive
investments in different types of medical equipment: a surgical
robot, an MRI machine, and a dialysis machine. Each of these will
require an upfront investment of $1.5 million, and each is of equal
importance to the hospital’s strategy.

o Based on input from key personnel, the chief financial officer
(CFO) of the hospital has created a table that projects year-end
cash flows for each of the potential investments:

Year

Robot

MRI

Dialysis

($1,500,000)

$200,000

$300,000

$500,000

$300,000

$400,000

$500,000

$400,000

$600,000

$500,000

$650,000

$500,000

$650,000

$750,000

$500,000

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Lecture 33: How Investors Use Net Present Value

o Each of the three opportunities will cost the same amount
upfront, each has different projected cash flows over time, and
each has no expected value after five years.

o Assume that the hospital requires a 10% return on whichever
investment it decides to make.

• For all three opportunities, the initial cash outflow is $1.5 million.

Because it is an outflow, it is a negative value in the NPV formula.

o Starting with the surgical robot, the CFO’s table indicates that the
anticipated future cash flows are $200,000 in year 1, with some
steady increases over time, to $300,000, $400,000, $500,000,
and $650,000. But we know that the value of $650,000 in year
5 is far less than $650,000 in today’s dollars, because it won’t
be realized until five years out and because of the 10% discount
rate—the rate we want to earn on the investment.

o If we plug $650,000 into the present-value formula, the result
is $403,599. That’s what those year-5 cash flows are worth in
today’s dollars.

o The following table shows the present value of each of the
projected cash flows for the robot:

Year

Surgical Robot 0 1 2 3 4 5

Year-end cash flow ($1,500,000) $200,000 $300,000 $400,000 $500,000 $650,000

Present value @ 10% ($1,500,000) $181,818 $247,934 $300,526 $341,507 $403,599

NPV ($24,616)

o As you can see, if we add up the present values of each of
the individual cash flows, including the upfront $1.5 million
investment, we get a negative result: -$24,616. The surgical
robot investment has a negative projected NPV. If the hospital
requires a 10% rate of return, it should not invest in the robot.

248

The following tables show the NPV for the MRI machine and the
dialysis machine:

Year

MRI

Year-end cash flow

Present value @ 10%

NPV

($1,500,000)

($432,698)

$300,000

$272,727

$400,000

$330,579

$600,000

$450,789

$650,000

$443,959

$700,000

$434,645

Dialysis

Year

Year-end cash flow

Present value @ 10%

NPV

($1,500,000)

$395,393

$500,000

$454,545

$500,000

$413,223

$500,000

$375,657

$500,000

$341,507

$500,000

$310,461

• If an investment opportunity has a positive NPV, it is an investment
worth making. It is one that is expected to create value because, in
simplest terms, the present value of expected cash inflows exceeds
the expected cost of the investment. If, on the other hand, the NPV
is less than 0, the investment is not worth making because it will
destroy value, with expected future cash flows that do not provide
adequate compensation for the original cost of the investment and
the risk involved.

• Both the MRI and the dialysis machines have positive NPVs, but
the MRI is the better investment because it has the higher NPV.

Rules for Calculating NPV

• There are several general rules to keep in mind when calculating the
NPV of any investment opportunity. The first of these rules is that
sensitivity analysis is important. Any quantitative model’s output is
only as good as its inputs.

• The second rule is that after-tax cash flows are normally the relevant
item to discount for most organizations.

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Lecture 33: How Investors Use Net Present Value

• The third rule is that these concepts can apply to those entities, such
as philanthropic organizations, that are concerned with outcomes
other than cash flows generated.

• The fourth rule is that when applying the NPV formula, we should
consider only incremental cash flows in the numerator of the formula,
o For example, assume that a company with several operations

in the southeast is considering opening a new facility in
California but will continue operating its other business units.
Which cash flows should be considered in evaluating the new
business proposition?

o The answer is only the incremental cash flows, the amount to
be invested in the new operations and the additional net cash
inflows that are expected to be earned from the new location.

• Finally, we must treat inflation consistently. That is, our projected
cash flows should be nominal, not discounted for inflation. After
all, that is the point of discounting: to put future nominal cash flows
into today’s dollars. If we put future cash flows into today’s dollars,
then discounted them for inflation, essentially, we would have
double-counted.

Suggested Reading

Brealey, Myers, and Allen, Principles of Corporate Finance, chapters 5-6, 10.
Mayo, Basic Finance, chapter 8.

Questions to Consider

1. Following the 2008 financial crisis, the U.S. Federal Reserve made a
conscious decision to reduce interest rates to spur the economy and
promote recovery. Keeping the NPV formula in mind, how would the
Fed’s policy actions promote its economic objectives?

250

2. Imagine that you have the opportunity to invest in a single-family home
in your neighborhood that is in need of some renovation. You believe
that you could purchase the home for $225,000 but would need to invest
$100,000 in repairs and upgrades to the house, including adding a
second story. You think that the construction will take two years and that
the $100,000 in costs would be spent evenly over that period of time.
You also believe that you will be able to sell the home for $450,000 at
the end of the two years, net of real estate commissions and other sales
costs. Is this a positive NPV project at a discount rate of 10%? Would
your answer change if the discount rate were 15%?

Steps for Applying the NPV Formula

1. Estimate the total upfront costs of the investment, usually
consisting of the purchase price, commissions, taxes, and the like.

2. Estimate the future cash flows expected to be derived from the
investment over the relevant time period. If the investment has a
finite life, such as a piece of machinery or equipment, estimate the
cash flows over that particular period of time. If the investment
is considered to be a perpetuity, such as an investment in a new
business, a piece of real estate, or a stock, estimate what you think
it will be worth at some future point in time, say, in 5 or 10 years.

3. Assess the riskiness of the cash flows.

4. Determine the appropriate discount rate and compute the NPV. If
the result is negative, it’s probably wise to avoid the investment.

5. Sensitize the key inputs—the projected cash flows and the discount
rate—to construct base-case, best-case, and worst-case scenarios.

6. Make the investment decision.

251

Lecture 34: Alternatives to Net Present Value

Alternatives to Net Present Value

Lecture 34

I n this lecture, we will discuss several other metrics for evaluating
investment opportunities: internal rate of return (1RR), the profitability
index (PI), and equity multiples. Although NPV is certainly the most
robust method for conducting such evaluations, it is not as widely used in
the real world as the 1RR or equity multiples, both of which are easier to
understand. However, as we will see, these other approaches should not
take the place of the more analytical NPV approach. The wisest course in
evaluating investments is to compute the NPVs on projected cash flows,
along with the appropriate discount rate, that is, the rate of return you think
should compensate you for the risk you are taking.

NPV and IRR

• As we saw in the last lecture, NPV is the sum of the present values
of any cash outflows required for a particular investment, plus the
present value of future cash inflows, such as dividends, interest,
rents, or other income. Again, all the anticipated cash flows over
time, both in and out, are restated in today’s equivalent dollars,
using a discount rate, which is an interest rate based in part on the
riskiness of the particular investment. If the NPV is greater than
0, the investment will create value. If the NPV is negative, the
investment can be expected to destroy value.

• As useful a tool as NPV is for evaluating investment opportunities,
it has some practical limitations and challenges when applied in
the real world. One of the difficulties is determining the proper
discount rate to use when computing the present values for the cash
flows an investment is expected to generate over time. Further, it
is difficult to interpret what NPV means beyond telling us whether
we should or should not make a particular investment. Investors
usually want more information, including the rate of return on the
potential investment.

252

• As a result of these shortcomings, some industries use a return
measure known as internal rate of return (IRR). Mathematically,
IRR is the discount rate at which the NPV is equal to 0—sort of a
breakeven discount rate,
o As we’ve discussed, NPV is:

NPV = Present value of future cash flows ( CF t ) - Initial
investment required (CF 0 )

NPV = -CF 0 +

CF, CF,

I.+<r (>+•■)'

o To find the IRR, we set the NPV equation equal to 0 and solve
for the missing variable, i.

Calculating IRR

• Imagine that you’ve been offered the chance to invest with some
partners in a piece of income-producing real estate, perhaps a
duplex that needs to be renovated and resold,
o The initial down payment required is $100,000, which includes
the budget for renovations; you will borrow $200,000 from a
bank to complete the purchase.

o You estimate that the investment will generate net income
before taxes of $8,000 in each of the next three years, including
interest payments to the bank. At the end of the three years, you
think the investment will be worth $320,000, at which point
you will pay back the loan of $200,000, leaving $120,000 to
distribute to the partners.

• With a discount rate of 8%, the NPV of this investment would be
calculated as follows:

NPV = ($100,000)+ $8 ’ 0Q °
v ' 1.08

$ 8,000

1.08 2

$128,000

1.08 3

NPV = $16,582

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Lecture 34: Alternatives to Net Present Value

• The result is clearly positive; thus, you can anticipate that this will
be a good investment, one that will earn over 8%. But what if you
are unsure about the discount rate to use and want to know the
actual rate of return on the investment? To address those questions,
you need to calculate IRR. For this calculation, again, you’re
solving for a particular discount rate in the NPV equation; to do
that, you set NPV equal to 0.

0 = ($ 100 , 000 ) +

$8,000 | $8,000 t $128,000

(l + x) (l + x) (l + x)

The unknown discount rate is about 14.1%.

• Asa rule, if the IRR from an investment opportunity is greater than
the rate of return you require on the investment, you should proceed
with the opportunity. If the IRR is less than the required rate of
return, you reject it. For example, if you determine that a project
has an IRR of 13% (NPV = 0 at a 13% discount rate), you make the
investment so long as you require less than a 13% return for that
particular opportunity.

• Unfortunately, for investment opportunities lasting more than two
periods, it is not possible to solve algebraically for the IRR using
the discounted cash flow equation. As a result, there are three ways
to calculate IRR:

o Trial and error. Simply try different discount rates until one
yields an NPV equal to 0.

o Graph the function. Calculate the first few guesses of a trial-
and-error approach. Graph these, then extrapolate to the
point where the graph crosses the NPV = 0 line to yield an
approximate IRR.

o Use a financial calculator or computer spreadsheet.

254

Limitations of IRR

• Although IRR is widely used and cited, it has some significant
drawbacks, one of which is the size problem.

o Consider, for example, an investment opportunity with a
100% IRR. That sounds wonderful, but what if the investment
requires only $10? It’s still a good deal, but not many investors
will get excited about it.

o Would you rather invest $10 and get back $20 or invest
$10,000 and get back $13,000? The latter has a lower IRR—a
mere 30% compared to 100% in the first opportunity—but
most of us would be far more interested in the latter investment
than the former.

o With NPV, we don’t have this problem because it takes into
account the actual amounts of cash inflows and outflows.

• Another shortcoming of IRR is a bit more complex. To understand
it, consider this question: Which investment would you prefer, one
that earns 10% and lasts for one year or one that earns 8% each year
for a total of four years?

o Longer-term cash flows may have lower IRRs, but many
of us would prefer to make such investments to avoid
reinvestment risk.

o Because the IRR is expressed only as a percentage, it says
nothing about the duration of the investment.

• Yet another shortcoming of the IRR has to do with mathematics.
Some investments, especially in a corporate context, have negative
cash flows for long periods of time. They might require research
and development, for example, or extensive construction. In other
cases, you may have an investment that generates cash flows at
some times and requires investment of cash at other times. The
problem in these situations is that you may get multiple answers to
the IRR equation.

255

Lecture 34: Alternatives to Net Present Value

o When you receive cash flows from an investment, you get to
reinvest them, of course. The 1RR approach assumes that you
can reinvest these cash flows in other projects earning the
same rates of return as the current project, which may or may
not be true. However, when you have to spend money on an
investment you already have, you are essentially lending money
to the project. Although the NPV formula can handle projects
that both throw off and require cash, the 1RR formula cannot.

o This makes 1RR a popular and common method for

analyzing venture capital and private equity investments.
These investment strategies usually require cash investments
throughout their lives but only one cash inflow at the end of the
project, perhaps an initial public offering or a sale of the asset
to another investor or firm.

• Finally, IRR does not help us compare two mutually exclusive
investment opportunities.

o Consider two potential projects: The first requires an

investment of $10,000 and is expected to return $12,000 in
a year. The second requires an investment of $1,000 and is
expected to return $2,000 in a year. The first has an IRR of
20%, and the second, an IRR of 100%. Should you jump on
the second opportunity? The answer is no because the first has
a higher NPV, equal to $909, versus the second, which has an
NPV equal to $818.

o The IRR leads to the wrong decision here because it does
not take into account the different scales of the projects. The
larger project has a smaller percentage return but a larger dollar
return. The NPV formula picks this difference up, but the IRR
does not.

Profitability Index

• The profitability index (PI) is defined as the NPV of an investment
opportunity divided by the amount of the initial investment. We can
think of it as the “bang for the buck” metric. As a CFO weighing

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investment options for your company, you might use the PI to rank
various alternatives under consideration. Then, working from the
highest-ranked opportunity to the lowest, you can invest in one
project after another until all the available funds are expended.

• Let’s work through an example. Imagine that a certain organization
has a budget for capital projects of $2 million this year, and the CFO
has five potential projects in which to invest. The NPV, required
investment, and PI for each of the projects is shown below.

Project

NPV

Investment

Required

$90,000

$900,000

0.100

$125,000

$1,100,000

0.114

$65,000

$500,000

0.130

$25,000

$500,000

0.050

$60,000

$400,000

0.150

• Ranked by PI, these projects would fall into the following order: E,
C, B, A, and D. Thus, the CFO could start with E, which requires an
investment of $400,000 and would leave $1.6 million left to spend.
Next would be project C, which requires $500,000 and leaves
$1.1 million. Project B would use up the remaining $1.1 million
of investment capital, while projects A and D would have to be
reconsidered at some future point in time.

Equity Multiples

• The equity multiple is commonly used in private equity and
venture capital investments. It is calculated by dividing the
cumulative amount of returns paid to an investor over time by the
capital invested.

• Assume that you invest $50,000 in a venture capital fund, and over
the five-year life of the fund, you receive a total of $125,000 in
distributions. Thus, the equity multiple is: $125,000/$50,000 = 2.25.

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Lecture 34: Alternatives to Net Present Value

• Obviously, the time value of money is ignored under this approach,
which differentiates the equity multiple from other valuation
methods. But the method is simple, and for certain types of
investments that are relatively short in duration, such as private
equity or venture funds, it can be a reasonable way of comparing
different funds or fund sponsors.

Suggested Reading

Brealey, Myers, and Allen, Principles of Corporate Finance, chapters 14,
17-18.

Collins, Johnson, Mittelstaedt, Revsine, and Soffer, Financial Reporting and
Analysis, chapter 11.

Easton, McAnally, Sommers, and Zhang, Financial Statement Analysis and
Valuation, chapter 12.

Questions to Consider

1. Using trial and error, can you approximate the IRR for a three-year
investment with the following estimated year-end, after-tax cash flows:

Initial

Investment Year 1 Year 2 Year 3

$25,000 $2,000 $3,000 $27,000

2 . A firm specializing in mergers and acquisitions purchases a privately
held company for $250 million, in the three years following the
acquisition, the company is able to pay dividends of $40 million, $45
million, and $50 million to the buyout firm. At the end of the three
years, the buyout firm sells the company to a larger industry player for
$350 million. What is the equity multiple for this transaction?

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Weighing the Costs of Debt and Equity

Lecture 35

I n order to fund operations and necessary capital expenditures, firms turn
to any number of potential sources, including borrowing money from a
bank or other financial institution, issuing notes or bonds to investors,
and selling shares of stock in the firm. Some firms issue convertible bonds,
a hybrid security that is a combination of a bond that pays interest, along
with a so-called “equity kicker,” a potential or contingent interest in the
issuer’s stock. Many firms use a combination of all these approaches to
raise necessary funds. In this lecture, we’ll look at the trade-offs between
issuing debt versus equity and explore the accounting, finance, and valuation
implications of such decisions.

Debt versus Equity

• In 1958, two academic researchers, Merton Miller and Franco
Modigliani, published a paper entitled “The Cost of Capital,
Corporation Finance and the Theory of Investment.” The premise
of their work was that the value of any firm is independent of how
it finances its business. That is, whether a firm finances its business
entirely with debt, entirely with equity, or with some combination
of the two is irrelevant in that the value of that firm will not change,
o Although this theorem sounds simple, it is considered a
cornerstone of corporate finance and has spawned significant
additional research.

o Despite the theory, however, the decision to issue debt, stock,
or a combination of the two can, in fact, affect the overall value
of a firm. By changing the capital structure of a firm, its value
may increase or decrease, depending on circumstances.

• A fundamental concept in finance is this: The cost of debt is
cheaper than the cost of equity. Investors in a company’s bonds
expect a lower return than investors who purchase stock in the same
company, all else equal.

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Lecture 35: Weighing the Costs of Debt and Equity

• Generally speaking, when investors purchase a company’s bond,
they anticipate receiving periodic payments of interest and a
repayment of the bond’s principal when it matures. For example, in
2013, Apple issued 10-year standard bonds. Anyone who purchased
one of those bonds expected to receive 2.415% in interest each year,
in addition to the principal amount of the bond when it matures.
There is no additional return to this investment.

• in contrast, investors who purchase a company’s common stock
understand that there will be much more variability in the ultimate
outcome. And because of this additional risk, investors expect to be
appropriately compensated.

o Although debt almost always requires periodic payments of
interest, dividends on stock are not mandatory; they are issued
at the discretion of a company’s board of directors. But because
a share of common stock represents an actual ownership
interest in the company, there is no ceiling on the return that an
investor might earn.

o If Apple stock goes up 20% this year and continues to pay
dividends, the company’s stock owners will have done much
better financially than the bond owners. Of course, the flipside
is also true. Thus, stocks are more risky than bonds, and
investors expect a higher return for owning them.

• Moreover, in the event of the insolvency of a firm, debt has
preference over equity in bankruptcy proceedings. In such
cases, stockholders usually lose all their investments in the
firm. Although bondholders may also get hurt by these events,
their losses are somewhat buffered by the fact that they receive
preferential treatment. Thus, bondholders receive lower expected
returns than stock or equity holders, simply because they assume
less risk.

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Other Debt and Equity Considerations

• A second significant difference between debt and equity is
that interest payments to bondholders are tax deductible while
dividends paid to shareholders are not. Our government subsidizes
the issuance of debt by providing firms with a tax deduction for
interest expense. This economic carrot can be quite significant and
definitely encourages increased borrowing and leverage.

o For example, consider a firm with a 30% combined state and
federal tax rate that issues 6% bonds; the company can deduct
30% of the total amount it pays on those bonds. The after-tax
cost of the bonds is actually 70% of the 6% rate, or 4.2%. This
is not an insignificant difference.

o Thus, at the margin, if a firm is deciding whether to issue debt
or stock, the value of the firm can be affected by the value of
the tax shield derived from the interest deductions over time.

• If debt is cheaper than equity and is tax favored, why don’t firms just
issue debt instead of stock, thereby increasing the value of the firm?
One answer is that unlike equity, debt has a maturity date and must be
repaid. Debt also typically requires periodic payments of interest. As
firms continue to pile on debt, the risks related to the firm’s potential
insolvency outweigh the benefits of the additional debt.

• Another fundamental difference between debt and equity relates
to corporate governance and control. Shareholders can elect
a company’s directors and approve certain matters regarding
executive compensation, mergers and acquisitions, and so forth.
Retail shareholders do not usually hold enough shares to sway
elections, but they still get to vote, while bondholders typically
do not. Usually, this would not have an impact on valuation, but
it might if a significant number of voting shares in a corporation is
held by one or a few individuals.

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Lecture 35: Weighing the Costs of Debt and Equity

Costs of Debt and Equity

• As we noted, debt generally requires periodic tax-deductible interest
payments. The cost of debt, is calculated with the following
formula: K d = z( l - t), where i is the interest rate on the debt and /
is the tax rate.

• The cost of equity, or K e , is trickier because it is equal to the
expected return that an equity investor anticipates from owning
stock, and this expected return is, in turn, derived from asset-pricing
models, such as CAPM.

o As you recall, the CAPM formula is: Expected asset
return = Risk-free rate + /^(Expected market return - Risk-free
rate). In discussing the cost of equity, the formula is written as
follows: K e = R + (fi x Equity risk premium).

o Assume, for example, that the 10-year treasury yield is 2.6%,
a company’s beta is 1.5, and the equity risk premium is 5%.
In this scenario, the company’s cost of equity would be:
2.6%+ (1.5 x 5.0%)= 10.1%.

• As an example, assume
that you plan to purchase
a home for $500,000; you
will put $100,000 down
and borrow the remainder,
$400,000. The $400,000
mortgage has an interest
rate of 4% before taxes.
To fund the $100,000
down payment, you sold
some stocks, which you

Borrowing money is often part of an
investment decision, both in business
and in our personal lives.

Weighted Average Cost of Capital

• Most capital projects or investments are financed with a
combination of debt and equity. To compute their costs, we use the
weighted average cost of
capital (WACC).

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monkeybusinessimages/iStock/Thinkstock.

estimate would have continued to earn 10% after taxes if you hadn’t
sold them. Your combined state and federal tax rate is 25%. What is
your WACC for this transaction?

o You took out a 4% loan for 80% of the home’s purchase price,
but remember that the 4% interest is tax deductible. Thus, the
after-tax cost of debt is actually 4% x (1 - 25%), or 3%.

o Meanwhile, the cost of equity is the opportunity cost related
to having money tied up in the house as opposed to the stock
market. You estimated that to be 10% after taxes.

o Clearly, the cost of the mortgage debt is cheaper than the cost
of the down payment, or equity. If you had sold $500,000
worth of stock to make the purchase, ignoring any possible
capital gains to be paid, the after-tax cost of the transaction
would be 10%; thus, the relevant cost of equity would be
10%. In contrast, if you had borrowed 100% of the purchase
price of the house, the relevant cost of capital would be
just 3%.

o However, as mentioned, we normally purchase houses
using both debt and equity, each with its own unique cost.
Therefore, we need to compute the WACC for funds used in
such transactions.

o In the case of the $500,000 home purchase, the WACC would
simply be 80% x 3% for the debt component, plus 20% x 10%
for the equity component; that yields: 2.4% + 2.0% = 4.4%.

• The WACC is important for three reasons: (1) It highlights the
different costs of debt and equity, taking taxes into account; (2) it
reflects the reality that capital investments usually employ a mix
of debt and equity; and (3) it provides the appropriate discount rate
to be used in computing NPVs to evaluate capital projects. That is,
for any capital project to create value, it must earn more than the
WACC used to make the investment.

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Lecture 35: Weighing the Costs of Debt and Equity

The formula for WACC is as follows:

+(*,(i-*y

\ d \ h

Where:

K e = cost of equity
K, = cost of debt

E = market value of firm’s equity
D = market value of firm’s debt
V=E + D

t = corporate tax rate
Using WACC

• We can use the WACC formula to estimate the cost of capital for
an entire company. For example, below are some salient figures
regarding IBM (using 2014 data):

o The company has long-term debt outstanding of about
$46.5 billion.

o Based on its most recent debt offering, IBM’s pretax cost of
debt is 3.625%.

o The company’s overall tax rate is 20%.
o IBM’s stock market capitalization is about $190 billion,
o Finally, IBM’s beta is 0.7.

• The last two pieces of information we need are the risk-free rate,
which is the yield on 10-year treasury bonds, and the overall equity
risk premium, which is the amount we expect the stock market to
outperform risk-free investments. Let’s assume a risk-free rate of
2.5% and an equity risk premium of 5%.

264

• To compute IBM’s overall WACC, we begin by computing the
company’s after-tax cost of debt: 3.625% x (1 - 20%) = 2.9%.

• To compute the estimated cost of equity, we use CAPM. We start
with the risk-free rate, here, 2.5%, and add to it the beta-weighted
equity risk premium, here, equal to 0.7, multiplied by 5%. Thus, the
cost of equity is estimated to be: 2.5% + (0.7 x 5.0%) = 6.0%.

• Finally, once we have estimated the costs of both the debt and the
equity, we can compute the WACC based on the relative values of
each that IBM has in its current capital structure.

o First, we add the company’s debt, $46.5 billion, and the
market value of its common stock, $190 billion. The total is
$236.5 billion.

o Dividing $190 billion by $236.5 billion, we see that equity
represents 80.3% of the company’s capital structure. Therefore,
debt represents 19.7% of IBM’s capital structure.

o The WACC is, thus, 80.3% x 6.0% (the cost of equity) + 19.7%
x 2.9% (the after-tax cost of debt). The result is about 4.8%.
This would be the appropriate discount rate IBM might use
today if it was funding a capital project using both 10-year
bonds and some equity, in about 80-20 proportions.

Suggested Reading

Brealey, Myers, and Allen, Principles of Corporate Finance, chapter 5.
Mayo, Basic Finance, chapter 8.

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Lecture 35: Weighing the Costs of Debt and Equity

Questions to Consider

1. As the owner of a successful fast-food franchise, you have been offered
the opportunity to open a second location in a neighboring community.
However, opening the second store will not be inexpensive; you
estimate the total capital commitment to be $200,000. Your local bank
has offered to loan you $120,000 for five years at a cost of 6.5% each
year. You would need to sell some stock and borrow against your life
insurance policy for the remaining $80,000 needed, and historically,
these other investments have increased by 11% each year. You expect
that your combined federal and state tax rate will average 25% over the
next several years. What is the WACC for this investment?

2. Using the WACC computed above, assume that you expect the new
location to generate after-tax cash flows of $20,000 per year for each
of the next five years (at the end of each year) and that the location will
be worth $235,000 at the end of the five years. What is the NPV of the
investment? Should you open up this new location?

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How to Value a Company’s Stock

Lecture 36

A s we’ve said throughout these lectures, investors should strive to
make value-creating investment decisions. In finance terms, we’ve
described a value-creating investment as one that has a positive
NPV, where the benefits received from the investment over time exceed the
amount invested, all viewed in today’s dollars. When investors and capital
providers lose sight of this fundamental principle, economic catastrophe
may ensue. Thus, in our final lecture on finance and accounting, we’ll keep a
close eye on the fundamentals. In particular, we’ll see how many of the tools
we’ve already discussed can help us determine whether a particular stock
might be under- or overvalued.

Reviewing Terms

• Let’s begin by reviewing some definitions, starting with
EBITDA. This metric is most easily calculated by starting with
a company’s operating income and adding back depreciation and
amortization expense.

• A second important term is free cash flows, that is, the cash flows
generated from a firm’s normal and recurring operations, less what
it spends on capital expenditures.

o This definition is perhaps the most critical one for stock
valuation because the residual cash that a firm generates after
investing in its own business should support its stock price.
That is, when you purchase a stock, you are really purchasing a
share of a company’s future free cash flows.

o One key attribute of free cash flows is that they should be
unlevered, free of the impact of any debt or leverage a company
might have.

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Lecture 36: How to Value a Company’s Stock

• The third definition we need to review is market capitalization, the
total stock market value for a particular company. It is calculated by
multiplying the total number of shares of outstanding stock by the
stock price.

• The last definition we need is enterprise value. This is the sum of
the market value of a company’s equity and the market value of the
company’s net debt—its long-tenn debt less its cash. If a company
has $100 million of long-term debt outstanding and cash in the
bank of $60 million, its net debt is $40 million. If a company has a
market capitalization of $200 million and net debt of $40 million,
its enterprise value is $240 million. Enterprise value reflects the
total market value of a firm—the minimum amount a buyer would
have to pay to purchase the firm.

Fundamental Analysis

• The general approach to valuing stocks is known as fundamental
analysis, which entails an examination of quantitative and qualitative
factors that might affect a company’s value. These might include
the company’s financial statements and ratios; its projected free
cash flows; its management team, strategy, and competition; and
even macroeconomic factors—all evaluated in the context of what a
company is selling for in the marketplace. The goal of fundamental
analysis is to detennine whether a stock is undervalued or overvalued.

• For valuation, it’s important to review a company’s market
capitalization and enterprise value compared to accounting data or
an accounting metric. Some common valuation metrics involve the
price-earnings ratio, as well as price-to-sales and price-to-EBITDA
ratios. Once these ratios are calculated for one company, they are
compared to the ratios of other companies in the same industry.

• Let’s walk through an example, using Apple. As of mid-2014,
Apple had about 6 billion shares outstanding and a stock price of
about $100 a share. Its market capitalization was, therefore, about
$600 billion. Apple also had debt outstanding of $29 billion and
cash and liquid securities of nearly $165 billion.

268

o Given these metrics, Apple’s enterprise value is: ($600

billion + $29 billion) - $165 billion = $464 billion.

o To calculate Apple’s price-earnings ratio, we divide its stock
price by its earnings per share: $100/$5.96 = 16.8.

o To compute the price-to-EBITDA ratio, we divide the market
capitalization by EBITDA: $600 billion/$59.1 billion = 10.2.

o We then would compare these ratios to the ratios of

competitors; to broad market indices, such as the S&P 500; and
to history. Collectively, these comparisons would enable us to
make some judgments about whether Apple’s stock appears
under- or overvalued.

Discounted Cash Flow Analysis

• Perhaps the most important fundamental analysis used to value
stocks involves discounted cash flow models, which integrate such
concepts as free cash flows, the time value of money, discount rates,
and the cost of a firm’s capital.

• At the most basic level, any company should be worth the NPV of
its expected future free cash flows. After all, when we buy a stock,
we are purchasing a pro rata share in all of the future earnings and
cash flows that company might generate. However, we know that
future cash flows are worth less than current ones and that there is
inherent uncertainty and risk in future cash flows. Thus, we need
to think about how to appropriately discount them to put those
projected future cash flows into their current equivalents.

• Discounted equity or stock valuation models involve several
steps. The first step is to compute the company’s free cash flows
for the past few years by examining historical financial statements,
primarily the statement of cash flows. The second step is to project
future free cash flows based on historical analysis and intuition.

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Lecture 36: How to Value a Company’s Stock

Predicting future cash flows is especially challenging for technology firms,
where new products are constantly being introduced and new competitors
routinely emerge.

o In the long run, we expect companies to grow at some steady
rate once they hit a certain size or level of sales. Most analysts
and economists consider a growth rate of 3% to 5% a year to be
reasonable once a company reaches a certain size.

o However, for some firms, especially those in technology, we
assume stronger growth rates for a period, followed by more
normal and modest growth rates. Of course, this depends on
the specific company and the industry in which it operates.

• Once we have predicted the company’s future free cash flows, we
must discount them to present-value equivalents. To do this, we use
the firm’s WACC.

• At this point, we will have our best estimate of the present value
of the company’s expected future free cash flows, which is, in
essence, an estimate of its overall value. We can then compare this

270

result to the actual enterprise value of the firm and make an initial
investment conclusion about whether the company appears over-
or undervalued.

• Before reaching a final conclusion, we should also step back and
reflect on our analysis and assumptions. Perhaps our projected
future cash flows are aggressive or overly conservative. We might
modify our assumptions and projected growth rates to see how
those adjustments change our conclusions.

Dividend Discount Model

• Let’s apply the steps in discounted cash flow analysis to a real-
world enterprise, an electric utility called Southern Company. As
of 2014, its common stock sold for about $45 a share, and it paid
an annual dividend of $2.05 per share. In the several years prior to
2014, Southern Company increased the dividend by about 3% to
3.5% each year.

• As a regulated utility company, Southern Company’s future
growth will likely be modest, in line with the overall growth in the
economy. Much of its return to shareholders will likely come in the
form of cash dividends.

• What is Southern Company’s stock worth? Let’s assume that next
year’s dividend will increase to about $2.10 a share. Let’s further
assume a WACC of 6% and that future dividends will continue to
increase by just 2% each year. Given these assumptions, can we use
a discount model to estimate a value for Southern Company?

• Southern Company stock almost sounds like a growing perpetuity, an
investment paying a dividend that is expected to increase each year.
The shortcut for calculating the present value of a growing perpetuity
is to divide the cash flow projected for the next year by the difference
between the discount rate and the expected future growth rate:

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Lecture 36: How to Value a Company’s Stock

Plugging in the numbers, we get:

. =$52.50.

(6% —2%)

This valuation approach is known as the dividend discount model.

• The problem with the dividend discount model is that many firms
pay only modest dividends or no dividends at all. Therefore, we
need a more robust discount model, one based on the company’s
overall projected free cash flows, discounted to present value.
Because this approach provides an overall enterprise value, we
will then need to back into what our model might tell us about the
company’s stock price.

Computing Free Cash Flows

• In an earlier lecture, we discussed a shortcut measure of calculating
free cash flows: subtracting CAPEXs from a firm’s operating cash
flows. We also saw that this metric reflects the firm’s leverage or
debt and that we must unlever the operating cash flows as a first
step. To do this, we add back to operating cash flows the amount of
interest the company paid during the year after taxes.

• Let’s walk through an example using Nike, the global athletic
apparel company. For the 2014 fiscal year, Nike reported cash flows
from operations of $3 billion, CAPEXs of $880 million, interest
paid of $53 million, and a tax rate of 24%.

o To compute free cash flows, we start with cash flows from
operations and add back the after-tax cost of interest Nike
incurred during the year. Because Nike paid $53 million
in interest before taxes and because interest costs are tax
deductible, we can estimate that Nike’s after-tax interest cost
was about $40.3 million, or $53 million x (1 - 24%).

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o Thus, Nike’s 2014 annual free cash flows were $2.16 billion,
calculated as follows: $3 billion + $40.3 million - $880
million. Again, this figure represents the amount of cash Nike
generated from operating and investing in its core business,
assuming the company had no debt at all.

• Let’s now do a discounted cash flow analysis to address the
question: How much should Nike’s stock sell for?
o Because Nike is a large, established company, we can assume
that it will continue to grow at a rate in line with the overall
global economy, say, 4% annually. Thus, we would assume that
Nike’s fiscal 2015 free cash flows would be $2.25 billion—4%
higher than 2014 free cash flows.

o To value Nike overall, we need to compute this estimated 2015
free cash flow as a growing perpetuity:

$2.25 billion

Here, g, or the predicted annual growth rate, is 4%. If we
assume Nike’s WACC to be 6%, the company would be worth:

$2.25 billion
(6% -4%)

$112.5 billion.

• Valuing stocks integrates many of the concepts we have covered
in these lectures. We start with free cash flows derived from
accounting disclosures. We then consider the company’s cost of
capital and input its anticipated future growth rate. For stable and
well-established companies, this exercise is fairly straightforward.
For companies that are still growing rapidly, such as Tesla or
Netflix, we would need to project future cash flows each year until
they stabilize, then discount all future cash flows accordingly.

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Lecture 36: How to Value a Company’s Stock

Suggested Reading

Brealey, Myers, and Allen, Principles of Corporate Finance, chapters 4, 19.

Collins, Johnson, Mittelstaedt, Revsine, and Softer, Financial Reporting and
Analysis, chapter 6.

Damadoran. The Little Book of Valuation.

Easton, McAnally, Sommers, and Zhang, Financial Statement Analysis and
Valuation, chapters 12-13, 15.

Questions to Consider

1. You are considering investing in Home Depot stock but would like to
compare the company’s recent operating performance to its competitors.
What are some companies that compete against Home Depot that you
could use for comparison?

2. Assume the following for a potential company you are considering
investing in. Further assume that the company has been in business for
some period of time and operates in a fairly stable industry.

• Most recent annual cash flows from operations: $100 million

• Interest expense in most recent fiscal year: $25 million

• Projected annual growth rate in cash flows: 5%

• Tax rate: 35%

• Annual anticipated future capital expenditures: $40 million

• WACC: 7%

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Based on this information, what is the company’s estimated enterprise
value (overall value)? How does the value change as the company’s
expected future cash flows increase? How does it change if the tax rate
decreases? How does it change if the company’s WACC increases?

275

Critical Business Skills:
Organizational Behavior

Clinton O. Longenecker, Ph.D.

Critical Business Skills: Organizational Behavior

Scope:

W e all work in all types of organizations: small, large, high-tech,
not-for-profit, family businesses, entrepreneurial start-ups, public
and government sector—-just to mention a few. What makes
working in organizations an interesting and, at times, challenging proposition
is the fact that these enterprises are made up of human beings. And, of
course, each of these human beings has his or her own unique personality,
talents, motives, communication styles, and personal idiosyncrasies that can
make going to work a blessing or a curse.

Human beings are social creatures, and human behavior within organizations
tends to follow certain recognizable patterns. The field of organizational
behavior was established to study those patterns and to develop practices
for bringing out the best in people in the workplace. Nobody tells you about
most of those practices when you join an organization, and once you are
working away at a demanding job, it’s easy to lose track of what you really
need to be doing to succeed in your position—and to lead others to do the
same. In this section of the course, then, we will learn the practices that are
most important for organizational success within your enterprise—both as
an employee and as a leader or potential leader.

Our study of organizational behavior will attempt to do two critical things.
First, it will help us understand why people behave the way they do at work.
Second, it will help us discover what leaders and professionals can and
should do to bring out the very best in the people that work within their
organizations. We will look at the critical concepts and strategies that we
can all use to maximize the performance and job satisfaction of everyone
involved in making an organization successful.

In short, understanding organizational behavior is really all about learning
how to create “people power” in the workplace. We will look at the science of
human behavior, and using those findings, we will develop tools to help put
people in the best position to succeed. As we’ll see, a thorough understanding

279

Scope

of organizational behavior can help all of us create competitive advantage
with people—and that’s a critical and vital skill for organizational success in
the 21 st century.

In these lectures, we will explore such topics as career success and survival,
the critical nature of leadership, the importance of great interpersonal skills
and emotional intelligence, and effective communication with coworkers
and employees. In addition, we will learn how to create an organizational
climate that maximizes human performance in the workplace, how to
create and foster teamwork with the people around us, and how effective
coaching and feedback can nurture great performance. Other topics
include understanding power and influence at work, managing your boss,
understanding and resolving conflict, and appreciating the ethical challenges
associated with success. Finally, we will look at how to lead and facilitate
the process of organizational change and how to develop ourselves to meet
the changing demands of our jobs. Throughout this section of the course, the
lectures will challenge your thinking, ask you to look in the mirror, and give
you specific action assignments to ensure that you know not only what to do
but how to do it.

In a nutshell, these lectures will better equip you to be successful in your
job, deliver better results for your employer, and create a track record of
performance that will lead to career success! ■

280

Achieving Results in Your Organization

Lecture 37

The Field of Organizational Behavior

• The study of organizational behavior attempts to do two critically
important things: First, it helps us understand why people behave
the way they do at work, specifically focusing on intentional
behaviors that contribute to business success and business failure.
Second, studying organizational behavior helps us discover what
leaders and professionals can and should do to bring out the very
best in the people that work in their organizations.

• In short, then, understanding organizational behavior is really
about creating “people power.” Organizational behavior can help
a leader create competitive advantage with people—a vital skill for
organizational success in the 21 st century.

The Busyness Continuum

• In a study of 6,000 business professionals, the great majority said
that the most important factor in career success was developing
a strong track record of delivering results. But the minutiae that
permeate our jobs on an everyday basis can distract us from that
goal. We need to understand what all those distractions are doing to
us if we’re going to put our focus back where it belongs.

• Visualize a continuum measuring how busy you are on a typical
day. From less to more busy, we have the following categories:
o Not Busy—living a quiet life with a minimum of activity

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Lecture 37: Achieving Results in Your Organization

o Busy—being actively and attentively engaged; living a life full

of activity, responsibilities, and commitments

o Really Busy—being engaged in constant, challenging, and
ongoing activity

o Too Busy—finding yourself overcommitted; being in a state of

constantly having more things to do than can be realistically
accomplished.

• If you’re like most professionals in the 21 s1 century, you probably
find yourself in the Really Busy category. Although that’s a
challenging spot to be in, it’s unfortunately just a fact of life in
today’s business world.

• But a growing percentage of working professionals regularly find
themselves in the Too Busy category. In fact, it’s not uncommon to
conduct a management development program and find that more
than 50% of the participants feel they’re too busy.

If you have a demanding job, it’s very easy to lose track of what you really need
to be doing to succeed in your position.

282

• When we’re too busy, our ability to communicate breaks down, and
our listening skills diminish. We tend to lose focus and attention
to detail. Problems that need our attention are left unresolved, or
they’re simply ignored altogether. Busyness can damage our ability
to focus our time and talent on doing the things that lead to getting
desired results.

S.T.O.P. Being So Busy

• When things in the workplace become increasingly pressurized,
fast-paced, and turbulent, it’s only logical to respond by trying to do
the same work that you’ve been doing quicker or to develop more
sophisticated and complex solutions to the logistical challenges
you face. But in fact, when things in the workplace get crazy, it is
imperative that we slow down and exercise self-leadership and
leadership of others with greater precision, passion, and persistence.

• An effective way to achieve this is through a model called S.T.O.P,
which stands for Sit, Think, Organize, and Perform. S.T.O.P. is
the process of slowing down and becoming more intentional and
mindful in the way you approach your work and life. The process is
very straightforward:

o Sit quietly, someplace where you won’t be disturbed.

o Think about what you really need to accomplish, as opposed to
everything else you’re supposed to do that may be less important.

o Organize yourself to place top priority on the results that
really matter.

o Perform based on your priority system, checking your results
to make sure that you are meeting your goals.

Strategic S.T.O.P.

• A strategic S.T.O.P. requires that you have a monthly, quarterly
or semi-annual “strategic planning retreat” with yourself to think
through and answer the following critically important questions:
What specific results do 1 need to deliver in order to be successful?

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Lecture 37: Achieving Results in Your Organization

What specific activities and practices do I need to engage in to
deliver desired results? Am 1 currently investing my time at work
on the activities that deliver the results we need? Your answers to
these questions will help you create real focus around what you are
being paid to deliver in your current position.

• Once you’re established that focus, here are three more questions
you need to answer if you want to deliver the results that you’ve
identified: Are my working relationships where they need to be to
deliver superior performance and results? Is there a talent or skill
that I need to work on to improve my performance? Is there a
problem or barrier that is getting in the way of my performance that
1 need to fix immediately?

• Finally, come up with a plan to measure your ongoing performance
at work to ensure that you stay on track. Don’t underestimate the
importance of this last strategic S.T.O.P. component because it
is imperative that all of us become proficient at self-leadership
to make sure we are getting results. Establish and maintain a
scoreboard for yourself to track the key performance metrics that
are most important for your success.

• Once you’ve answered the strategic S.T.O.P. questions for yourself,
it’s time to sit down with your boss and share your plan. This will
allow you to make sure that the two of you are on the same page as
you seek your boss’s input, create proper alignment, and open up
critical channels of communication with him or her. Most bosses
are really busy, and they will appreciate the fact that you are trying
to help them focus on delivering better performance.

Daily S.T.O.P.

• In essence, a daily S.T.O.P. is just a more detailed, shorter-term
version of the strategic S.T.O.P.—but paying attention to its details
will pay big dividends. As with the strategic S.T.O.P, the first step
is simply to sit. Start each day by slowing down, being still, and
finding a quiet and isolated place where you will not be disturbed.

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Research shows that sitting and relaxing in this fashion causes
various pathways in the brain to open up, and doing this daily gives
us better access to important stored information that we can use for
handling each day’s challenges.

• You need at least 15 minutes to refocus your thoughts from the
urgent, pressing issues of the moment to the key activities of the
day and the things you really need to get done. Wrap your thinking
around these questions: What specific results am I being paid to
deliver? What activities will get me there today?

• The third step, again, is to organize. It is imperative that you
organize your thinking to develop a performance script for the
day. Identify a realistic list of specific results and activities that
you must accomplish on this day. Once you have the activities
mapped out, realistically estimate the amount of time you’ll need
to complete each one.

• Next, determine who you will need to include in each activity.
Make sure you pull key people into this thought process; doing so
can make a real difference in the outcome. Once your activities are
planned, you know roughly how long each one should take you, and
you’ve figured out the key people you’11 need to involve, determine
what activities you can take off your list.

• Finally, prioritize the remaining items on your list and develop
a written plan of attack. The product of this process is your
performance script for the day. Now you’re ready to move to the
final step of the daily S.T.O.R exercise: Perform.

• As your day unfolds and you implement your plan of attack, take
five minutes halfway through the day to review your plan and make
adjustments. At the end of the day, take another five minutes to do
a brief review of what you did and didn’t accomplish. Those five-
minute assessments will be invaluable in helping you develop your
plan for the next day.

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Lecture 37: Achieving Results in Your Organization

Make Planning Routine

• Take the time on a regular basis to figure out exactly what your
boss really needs and wants from you and how to use your time in
the best way to produce those results. There are no magic bullets or
secret elixirs for improving performance. The only real way to go
about it is with careful thought, planning, and follow-through.

• But by spending just 25 minutes a day on those activities, you can
achieve wonders. Keep in mind that 25 minutes out of a nine-hour
workday in only 4.62% of your day.

• Research on high-performance leaders shows that when people use
that small percentage of each day to S.T.O.P., they are rewarded with
greater job satisfaction, improved working relationships, reduced
stress levels, and significant improvements in both the quality and
quantity of their performance. In fact, research has found that by
investing less than 5% of your workday in the S.T.O.P. process,
you can improve your performance by anywhere from 12% to more
than 30%—a great return on your investment.

• The beauty of studying organizational behavior is that the lessons
we learn can be applied in almost any organization or situation
in which people need to work together. If you can learn to lead
yourself and others to consistently achieve the results that your job
requires, you’ll be a highly valued part of your organization.

Suggested Reading

Lencioni, The Advantage.

Longenecker and Simonetti, Getting Results.

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Questions to Consider

1. Why is understanding organizational behavior important for your
career success?

2. What specific results are you being paid to deliver for your organization?
Are you and your boss on the same page with regard to this question?

3. Have you identified the specific workplace behaviors and actions that
are necessary for you to achieve the results expected of you?

4. Do you consistently use your time and talent to do the things that will
deliver desired results for your organization?

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Lecture 38: The Value of Great Leadership

The Value of Great Leadership

Lecture 38

E ffective leadership is essential in any organization. It’s a skill for
which some people have natural talent, but it’s also an ability that can
be cultivated. Great leaders—from such wartime figures as General
Dwight D. Eisenhower to such business innovators as David Packard—tend
to use a very specific set of skills and practices to get great results from the
people they work with. And once you understand those skills and practices,
you can make yourself into an effective leader, too.

The Importance of Leadership

• The practice of leadership is becoming increasingly important
in our ultra-competitive marketplace because effective leaders
can dramatically impact a wide range of critically important
organizational performance variables. Leadership can affect
innovation, transformation, productivity, efficiency, employee
turnover, workforce motivation, and job satisfaction.

• Good leaders tend to bring out the best in all of us, and they typically
make good things happen. Meanwhile, poor and ineffective leaders
tend to make our work lives problematic when things are already
challenging enough. In fact, they can make it tough to get out of bed,
come to work, keep a positive attitude, and actually get work done.

• Ideally, a leader is someone who has the talent and character to
influence others in productive and positive ways—although we
do not have to look too far into history or the newspapers to find
plenty of leaders who used their talents for destructive and even
evil purposes.

• Leadership is all about connecting with people and doing the things
that followers need so that they can be successful. Remember,
successfully delivering desired results is the key to career success
and survival.

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Two Components of Effective Leadership

• At its core, effective leadership is always based on the interaction
of two critically important factors: competency and character.

• A leader is competent when he or she possesses the requisite
skills and talents necessary to successfully help people achieve
desired results in a given situation. Put simply, leaders know what
they’re doing.

• Leaders have character when they possess the moral and ethical
underpinnings necessary to do the right thing and lead their people
in a principled fashion. When leaders have character, it means
that their people can count on them to do the right thing. A boss
who lacks character and a strong moral compass can turn a work
environment into a disturbing, distressing, and distrustful place.

• Taken together, competency and character create a leader’s
trustworthiness. When people trust their leader, good things happen.
A leader’s competency and character can have a powerful impact
on the leader’s followers, causing them to be motivated, supportive,
and loyal to their boss and the organization.

• Conversely, when we find ourselves working for a leader we deem
untrustworthy because of a lack of competency or character, our
focus shifts from doing our job and getting results to finding ways
to make up for our boss’s shortcomings.

Six Schools of Leadership

• Six leadership schools of thought can make a real difference in your
understanding of leadership. These schools provide us with some
key leadership takeaways.

• The trait leadership school: This line of thinldng holds that it
is critically important for all of us to know our strengths and
weaknesses as leaders. If we are serious about being successful
as leaders, we need to develop the necessary talents, skills, and
persona for any given position.

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Lecture 38: The Value of Great Leadership

• The behavioral leadership school: This school professes that leaders
can and must demonstrate a real concern for people. They need to
balance their concern for the task of getting results with a genuine
concern for their employees.

• The contingency or situational leadership school: In this theoretical
camp, effective leaders are those who take into account the
circumstances under which they are asked to lead, then develop an
appropriate leadership style to meet the demands of that situation.
Leaders must diagnose and clearly understand the dynamics of the
group that they are being asked to lead and the circumstances under
which they are being asked to operate.

• The transformational/charismatic leadership school: This school
makes a compelling case that certain leaders can have a powerful
and lasting impact on followers because of their passion and their
charismatic personalities. Great leaders use their view of the
future and their personalities in positive and powerful ways to
affect their followers.

• The results-based leadership school: This school embraces the
approach recommended by Stephen Covey, the author of The Seven
Habits of Highly Effective People : Start with the end in mind. This
growing leadership style works in reverse by first identifying the
desired goals and outcomes that leaders must achieve for success,
then cultivating the specific behaviors and practices that will enable
them to move their followers in that direction.

• The psychological or emotional intelligence leadership school: This
school cites a growing body of research that makes a strong case for
a leader’s emotional intelligence as vital to his or her success. As a
leader, it is imperative that you know and understand how to work
and connect with all kinds of people.

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Effective leaders make sure their team members know what’s expected of them
and how to achieve it.

Focusing on the Mission and Results

• A leadership study that engaged more than 500 managers in more
than 100 focus groups identified several common attributes of
great leaders.

• Great leaders realize that the first and most important job of any leader
is to create focus and a clear sense of purpose for their followers.

o Whether it’s Abraham Lincoln’s unrelenting focus on saving
the Union or Henry Ford’s goal to build an affordable car for
the masses, great leaders create a vision that their followers
know, understand, and can believe in.

o During the Second World War, General Dwight D. Eisenhower
was renowned for his ability to manage huge projects, such as
the D-Day landings. He had an uncanny talent for effectively
delegating work and letting each person know exactly what he
or she needed to do for the effort to be a success.

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Lecture 38: The Value of Great Leadership

• Most study participants said that great leaders have the ability to
balance concern for the task and getting things done with great
concern for their people. John Chambers, the longtime CEO of
Cisco Systems, is famous for his emotional intelligence and his
passion for connecting with everyone in his organization. His
organization makes it a priority to hire and develop leaders who do
the same, because such leaders understand that motivated people
and purposeful social networks are key to success.

• Great leaders are also recognized for their prowess in knowing how
to get others to come together and work as a team. Charles Coffin,
the founder and CEO of General Electric, began his career in the
shoe business. But because of his uncanny ability to get scientists to
work together and cooperate in research laboratories, he is credited
with creating one of the most enduring and widely emulated high-
tech enterprises in the world.

Preparing Followers

• The best leaders frequently receive great acclaim for their
willingness to properly equip and prepare their people for success.
These leaders take the time to plan and effectively communicate
strategies to their people, both to create a sense of ownership and so
that everyone knows what is coming.

• The automotive genius Henry Ford was a pioneer in training and
properly equipping his workforces to they build cars quickly and
cheaply. Moreover, he believed in trying to find ways to help people
do their work without difficulty, which was unheard of back in the
late 19 th and early 20 th centuries.

• One of the more interesting attributes of great leaders is the fact that
they have the habit of making it easier for people to get their work
done. They do this through rapid problem solving, ongoing process
improvement, effective and timely decision making, and the ability
to quickly remove performance barriers.

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Integrity and Transparency

• In the leadership study, great leaders were consistently described as
having character and integrity. Study respondents said that the very
best leaders are trustworthy in that they demonstrate principled
behavior, even when no one is watching, and they show that their
word is always reliable and dependable.

• The cofounder of Hewlett-Packard, David Packard, was recognized
as one of the top CEOs of all time—not just because of his business
prowess, but because of his passionate belief in the dignity of
people and the high ethical standards he set for himself and for the
members of his entire organization.

• We all want to follow and work for people that we can respect,
whether it’s the CEO of our company or our immediate supervisor.

The Work-Life Balance, Passion, and Mojo

• One of the leadership study’s more provocative findings was
that great leaders were credited with not wasting time and with
operating in a fashion that helped them create and maintain a work-
life balance for themselves. Importantly, they did the same for
their employees, in spite of the fact that they were in exceptionally
demanding positions.

• The very best leaders work hard to maintain this “tightrope”
balance, and they encourage the people who work for them to do
the same. This balance is critically important for long-term success
in business and in life.

• Great leaders demonstrate passion, energy, excitement, enthusiasm,
gusto, and “mojo” for what they are doing. They go about their
business in a highly motivated fashion, with vitality that creates
momentum and drive for the people who follow them.

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Lecture 38: The Value of Great Leadership

• When people talk about such leaders as Sam Walton, Bill Gates,
or Michael Dell, they inevitably describe them as truly excited
and passionate about their mission, their work, and the lives they
are changing.

Suggested Reading

Drucker, Managing for Results.

Ulrich, Zenger, and Smallwood, Results-Based Leadership.

Questions to Consider

1. If you are a leader at work, can you explain the specific reasons that
people will want to follow you?

2. If you are currently in a leadership position, do you possess the specific
skills and competencies necessary to bring out the best in others? If not,
what are you doing to improve?

3. Do you lead by example and demonstrate character and principled
behavior in everything you do? If not, why not, and what are the costs
of not doing so?

4. If you are in a leadership position, are you doing the things that enable
your people to perform in an optimal fashion?

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Emotional Intelligence in the Workplace

Lecture 39

W orkplace relationships have the potential to create real drama,
problems, and even pain because some people don’t know or
don’t care to think about how to work effectively with others.
Such disruptions can make your professional goals extremely difficult to
reach. To counter that, this lecture will examine the importance of having
360-degree working relationships and what these relationships look like.
We’ll also discuss the importance of developing your emotional intelligence,
which can have a real impact on your ability to work well with others.

The Importance of Good Relationships

• To be successful in modern organizations, we need the help of other
people. Having great working relationships is a critical gateway to
getting the help we need. The statement, “No man or woman is an
island” is especially true at work.

When we get along with people at work, stress levels go down, and there is far
less drama in the workplace.

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monkeybu s ines s image s/iS tock/Th inksto ck.

Lecture 39: Emotional Intelligence in the Workplace

• When we get along with the people at work, there is almost always a
better flow of information and stronger communications. We know
that people are more willing to help one another, share knowledge
and experience to promote learning, and work together to solve
problems and achieve goals.

• In addition, the people we work with can have a significant impact
on our willingness to come to work, our attitudes when we get
there, and our willingness to stay with our current employer. Great
working relationships can be a tremendous source of motivation,
encouragement, and satisfaction.

Organizational Networking

• Organizations today are complex places, and the greater the
complexity, the more difficult it can be to get things done. But
you can handle that complexity by building a network of human
connections and great relationships within it.

• The organizational chart of your own enterprise can appear
daunting. But it looks a lot less so if you can say, “Oh, I know
Cindy over in IT,” or “Shannon in HR can help us,” or “I bet that
Larry in Operations will know.”

• It is critically important to identify the key people in your
organization with whom you need to develop mutually beneficial
working relationships and to take proactive steps to foster and
nurture these human connections. This requires great people skills,
proper focus, and time.

Effective 360-Degree Working Relationships

• It is a career imperative that we forge effective 360-degree working
relationships with people above us, our peers and coworkers, and
if you’re in a leadership position, the people that report to you. An
effective working relationship is one that fosters ongoing support
and positive interactions that facilitate the ability to get results in
a healthy, sustainable way. The 360-degree component means that
you need effective relationships with everyone you work with.

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• In business publications, it is not uncommon to read provocative
accounts of boardroom brawls, bitter disputes among research
scientists, or workgroups at war. Organizations often straggle
because of the inability of people to come together, work together,
and leverage their collective talents. Conversely, when people make
working relationships a real priority and work hard to develop their
people skills, great things can happen.

• Research for the book Getting Results found some reoccurring
themes of great working relationships that are important to keep
in mind.

o First, there is the relationship part of the equation. Effective
working relationships are based on each party demonstrating
mutual respect for the other, engaging in acts of common
courtesy, behaving appropriately, and showing trust.

o Second, there is the working part of the equation. Effective
working relationships are based on mutually understood
performance expectations and needs, as well as a shared sense
of responsibility and ownership for the work to be done.

Analyzing Your Work Relationships

• Now that you know what good working relationship look like, how
do you go about developing them with the people with whom you
need to work to be successful? The following exercise can get you
thinking about who those people are.

• On a sheet of paper, list all the people that you count on to get your
work done. Then, prioritize your list in order of importance and the
impact that each of these people has on your ability to deliver. Next,
candidly rate the quality of each of these working relationships
using the following categories:

o Non-working relationships are broken connections. They’re
relationships in which we really struggle to interact effectively
and work with people.

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Lecture 39: Emotional Intelligence in the Workplace

o Strained working relationships are relationships in which we
can work with people but don’t enjoy doing so. These often
involve recurring tension and unpleasant undercurrents.

o Positive working relationships involve folks we get along
with quite nicely. These relationships are productive, pleasant,
and cooperative.

o Great working relationships are strong connections where we
know the people we’re working with quite well, and they know
us. We know what we are trying to get done, and we have a
shared sense of purpose and responsibility.

• In the first two categories, your working relationships are not where
they need to be. Whether you are willing to admit it or not, these
relationships hurt and hinder your ability to deliver desired results
and enjoy work. In a nutshell, these are performance-damaging
relationships that need some real attention.

• If any relationship is not working, you should respond to the
situation as you would any other performance problem. You need to
analyze the situation, identify the root cause of the problem, select
appropriate action, and implement the necessary changes.

• If you have performance-damaging relationships that are holding
you back, it’s your responsibility to take action. Don’t assume
that time will heal or fix real problems that prevent people from
working together.

• Occasionally, people who need each other to get things done
simply don’t like each other. Or they get off to a bad start that is the
beginning of something that only gets uglier. More often, though,
strained working relationships degenerate over disagreements,
problems, or frustrations concerning issues of substance that never
get discussed or appropriately resolved.

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• The second two categories—positive and great working
relationships—can be classified as performance-enhancing
relationships. These relationships need to be protected and nurtured
by continuing to do the things that made the relationship work in
the first place.

• Certainly, if we neglect the relationships, stop communicating, or
cease demonstrating concern and empathy for the people in our
performance-enhancing relationships, they can degenerate, just as a
neglected marriage or dating relationship might.

Developing Emotional Intelligence

• The primary way you can help heal broken working relationships is
through developing emotional intelligence. Put simply, emotional
intelligence is the ability to recognize and manage your own
emotions and those of people around you.

• In 1998, Harvard psychologist Daniel Goleman wrote a
breakthrough book entitled Working with Emotional Intelligence.
It had always been assumed that if people had great cognitive
intelligence or a high IQ, then they would be successful in their
careers. But Dr. Goleman’s research found that a person’s emotional
intelligence, or EQ, actually plays a more crucial role than IQ in
terns of long-term career success.

• Some people seem to have greater natural ability to empathize
than others. But there are four particularly significant aspects of
emotional intelligence that you can develop: self-awareness, self¬
management, social awareness, and relationship management skills.

Dimension 1: Self-Awareness

• People with high self-awareness recognize and understand how
their emotions affect their behavior and thinking. They also have
an accurate assessment of their strengths and weaknesses, which
enhances their self-confidence. And they understand that their
emotions and behavior can have a powerful impact on the people
around them.

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Lecture 39: Emotional Intelligence in the Workplace

• People with high self-awareness are good at not letting their
emotions have a negative impact on their relationships with other
people, and they are open to receiving feedback from others.

• In contrast, people who lack self-awareness often can’t control their
emotions or make no effort to control them. It is important to note
that highly effective people typically have great self-awareness and
find ways to control their emotions.

Dimension 2: Self-Management

• The second dimension of emotional intelligence is self¬
management, which allows highly effective people to stay focused
in order to achieve a desired goal. People with this dimension
demonstrate self-control, transparency and candor, and optimism
and persistence in pursuing goals.

• People who have strong self-management capabilities tend to
be self-motivated and set challenging goals for themselves and
others. They are willing to work hard and demonstrate flexibility in
adapting to changing situations or dealing with problems.

• In a nutshell, people high on this dimension know what they want
and manage themselves in a fashion that increases the likelihood
of success.

Dimension 3: Social Awareness

• The next two dimensions of emotional intelligence shift from
understanding and managing oneself to focusing on other people.
Social awareness is the capacity to sense and understand how others
feel, want, and need and to take an active interest in the concerns of
other people in a given situation.

• People with great social awareness are good at reading and tuning
in to the situations in which they find themselves. They seek to
understand the organizational context to help them make sense of
the things going on around them.

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• This social empathy helps people demonstrate sensitivity toward
others, which in turn, allows them to recognize other people’s
accomplishments and offer advice and feedback in ways that don’t
offend people.

Dimension 4: Relationship Management Skills

• The final dimension of emotional intelligence is possessing strong
relationship management skills. These skills allow an individual to
influence the emotional tone of a group, to articulate a direction or
vision, and to influence the behavior of other people in positive and
sustainable ways.

• People who are strong in this area are good at getting people to
unite around the things that are important and at directing them to
where the group needs to go to be successful. They typically lead
by example and possess the ability to deal with difficult people in
confident and straightforward ways.

• People who have effective relationship management skills are
willing to put energy into developing others, they’re quick to
resolve conflicts and disagreements, they’re team oriented, and they
look for ways to inspire others and initiate needed change.

• It is critically important for all of us to invest time and energy
in our working relationships and to look for ways to maintain,
motivate, and encourage others to experience the benefits of
working together.

Suggested Reading

Goleman, Boyatzis, and McKee, Primal Leadership.
Longenecker and Fink, “Fixing Management’s Fatal Flaws.”

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Lecture 39: Emotional Intelligence in the Workplace

Questions to Consider

1. If we asked your coworkers to describe what is like to work with you,
what would they have to say? Would they say you are easy to work with?

2. Have you taken the time to clearly identify the people that you
absolutely, positively need to have great working relationships with in
order to do your job effectively?

3. Do you invest the time and energy necessary to build and maintain
quality working relationships with the people around you?

4. Do you have a plan to improve your relationships by developing your
“people skills” and becoming more emotionally intelligent?

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The Art of Effective Communications

Lecture 40

L anguage and communication techniques are vital, but the foundation
of effective communications is wanting to be understood by the other
party—and desiring to understand what the other party is trying to
communicate to you. Effective communication is all about the motivation
behind the presentation of information. If we really need to get an idea
across to someone, we can always find a way to make ourselves understood.
In this lecture, we'll look at why effective communication practices are so
important and how to implement them in your organization.

Communication Problems

• In organizations, leaders frequently lack the motivation to learn
effective communication methods, either because they don’t
understand their importance or because they overestimate their
own communication skills. And people within the organization
who are strongly motivated to communicate are often given the
message that what they have to say isn’t valued. As a result, they
sometimes lose their motivation to communicate and, ultimately, to
work altogether.

• At the heart of the communication problems within many

organizations is a misunderstanding of the nature of effective
communications. Communicating, especially in the workplace, is
not simply about sharing information.

• Well-known Chicago journalist Sydney Harris captured the

essence of this important point: “The two words information and
communication are often used interchangeably, but they signify
quite different things. Information is giving out; communication is
getting through.”

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Lecture 40: The Art of Effective Communications

Getting Through

• People in organizations typically have three burning communication
needs:

o First, we all need the information that is necessary to do our
work efficiently and effectively. This can include knowing and
understanding such information as current job assignments
and responsibilities, instructions and updates on projects,
performance feedback, tactical plans, or perhaps something as
simple as the deadline for a report.

o Second, we all need to be informed about the things going on
around us that affect our future. This includes such information
as current operating performance, new and future market
opportunities, personnel changes, and new technologies.

Knowing that we have a voice
and that others are willing to
listen has a powerful impact
on our job satisfaction,
motivation, and commitment
to an organization. But leaving
any of these three basic
communication needs unmet
causes people to divert their
focus from getting things
done. Instead, they turn to
seeking out the information
they want and need—or they
spend time trying to find
someone who will listen to
their concerns.

Ironically, the sheer number of
communication technologies
available today can make it more
difficult to communicate effectively.

Third, we need the means and opportunities to make our voices
heard when we want to raise a concern, get a question answered,
identify a business opportunity, share a new idea, make a
suggestion, or offer input
on an important issue.

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• Why does this happen? Consider these possible factors:

o First, organizations often have a great deal of information
swirling around inside them that is not properly packaged to
satisfy people’s needs.

o Second, in today’s environment, we are all wrestling with an
unprecedented volume of data and other information. Ironically,
this problem is caused by all of our new communication
technologies, such as e-mail, instant messaging, text messages,
and social media. We can easily find ourselves operating on the
edge of information overload.

o Third, our workplaces are much more diverse than in the past,
which adds another degree of complexity to the communication
process that we all need to take into account. Such factors
as generational differences, culture, and educational and
socioeconomic backgrounds can affect our ability to
communicate effectively with one another.

Tools for Fixing Broken Communications

• People in any organization want an overall communication process
that is ongoing, organized, systematic, and designed to meet their
needs, rather than something that is pell-mell, ad hoc, or crisis driven.

• The leader of an organization doesn’t need to be a communication
genius to establish a highly effective communication system.
Much of what leaders need to know about establishing good
communications within their organization is readily available
to them, if they’re willing to ask their employees for input and
suggestions and listen attentively to the answers.

• Do you and your coworkers and employees have a systematic
approach to ensuring that people have the right information, at
the right time, at the right place, and in the right form to be able to
get their work done? If not, it may be time to look at the types of
information that the people in your organization need to be more
effective, then build out the practices that can help meet these needs.

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Lecture 40: The Art of Effective Communications

• Valuable tools address the communication needs we’ve identified.
The first need is for real communications that put people in a
situation where they can successfully perform their jobs. Here are
some communication practices you can use to help meet that need:
o Conduct regular one-on-one performance planning sessions to

clarify performance expectations

o Provide written instructions, policies, and work procedures that
people can access easily

o Implement ongoing one-on-one feedback and coaching meetings

o Develop organizational cultures that encourage regular
interactions with superiors and coworkers

o Use team meetings to share new information and performance
feedback

o Provide information to people on an ongoing and systematic
basis about the status of current projects and important programs

o Employ electronic and web-based information portals to
provide people with current performance data and information.

• The second need we discussed was that of being in the loop—
the importance of giving people in your organization a clear
understanding of what is going on around them. Communications of
this sort are designed to give people the context to better understand
the “big picture” of the enterprise and where they fit within it. Here
are some tools you can use for that purpose:

o Run effective and time-sensitive staff meetings

o Conduct town hall meetings where leaders and workers share
important information about what is going on in the organization

o Build web pages for internal use that provide employees with
information they want

o Use organization-wide voicemail blasts to communicate about
big events, breakthroughs, and successes

o Employ teleconferences and web-based informational meetings
to keep people informed without time-consuming travel

o Create electronic and whiteboard information postings to
provide up-to-date information about important issues

o Send out informational update e-mail blasts

o Produce informational videos that deliver accurate information
in a dynamic fashion.

• Third, we discussed the importance of providing employees with a
voice and an opportunity to express their concerns, offer input, and
have their questions answered. You can make that possible with a
number of proven practices, including the following:
o Get leaders to engage and empower workers to take greater
control over their work through participative leadership

o Hold brainstorming meetings and input sessions with small
groups or on a one-on-one basis with leaders and employees

o Use team-based problem solving to solicit employees’ ideas
about how to deal with organizational problems and perfonnance

o Implement continuous improvement processes

o Make use of employee surveys, suggestion systems, and
hotlines for gathering additional employee input

o Conduct regular, effective staff meetings where employees can
express concerns, share ideas, and voice their opinions with
their immediate supervisors.

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Lecture 40: The Art of Effective Communications

Lessons for Effective Communication

• Effective communication practices are essential for a well¬
functioning organization. But it’s important to recognize that they
don’t necessarily ensure success unless the people who are doing the
communicating are viewed as trusted sources of information. Leaders
need to be able to deliver and receive infomiation in a highly effective
fashion. That’s why leaders and employees need to engage in all
communication-related practices with both character and competency.

• Communicating effectively doesn’t come naturally to everyone.
Although it’s easy to criticize the communication failings of
others, it can be difficult to see the flaws in our own communication
skills. Below are six lessons that can improve your effectiveness
as a communicator:

o Take every communications opportunity seriously. Know
that each and every opportunity to communicate in an
organizational setting is either a problem-solving experience or
a problem-creating experience, based on our actions.

o Your credibility is key. Never underestimate the importance of
the credibility of the communicator. If you give other people
inconsistent information or make them a promise that you fail
to keep, people will learn quickly that your words aren’t worth
their time and attention.

o Be self-aware. Self-awareness encourages us to know our
strengths and weaknesses as communicators and to understand
how our emotions can affect our exchanges with others.

o Be socially aware and empathetic. It’s important to develop
your social awareness and empathy in order to tailor your
message to meet the needs of your audience.

o Exercise self-management. Self-management can play a critical
role in helping you improve as a communicator. You need to have
the ability to monitor your own speaking and listening practices
and take corrective action when you discover them lacking.

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o Listen. The cornerstone of every relationship is our ability
to communicate, and listening is an essential part of it. That
means you need to develop and refine your listening skills with
everyone you work with, from your boss, to your colleagues,
to your employees, to the person from IT who fixes your
computer. If you can’t listen to what’s on people’s minds,
you won’t be able to help them get their work done, and you
probably won’t be able to get their help in completing yours.

• Remember, effective communication is about speaking so that
other people are willing to listen, and listening so that other people
will be willing to speak. Whether you’re a boss or an entry-level
employee, make sure that your communications with the people
you work with don’t flow only in one direction. Express yourself
clearly, but always be willing to listen and encourage an open
exchange of ideas.

Suggested Reading

Carnegie, How to Win Friends and Influence People.
Hauden, The Art of Engagement.

Questions to Consider

1. In your workplace, what are the problems created by ineffective
communications?

2. Do you know exactly what information you and your coworkers need to
be effective in your jobs?

3. Are you effective in keeping people informed about what is going on in
the workplace and why it’s important?

4. Are you careful to listen to what people are sharing with you, and do you
have a practice in place to solicit ongoing feedback from your employees
about things you need to know and understand to be effective?

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Lecture 41: The Motivation-Performance Connection

The Motivation-Performance Connection

Lecture 41

M otivation and performance improvement are two of the most
researched, popular, and written-about subjects in the domain
of organizational behavior. Every company needs to operate
at peak efficiency in order to survive and thrive. There’s simply no room
for unmotivated employees or subpar performance, and any company
that accepts poor or even mediocre employee performance is unlikely to
be around for long. If you hope to lead people in the business world, it’s
critically important that you have a thorough understanding of how to create
a workplace environment that brings out the best in everyone.

The Importance of Motivation

• Company leaders are well served when they focus serious attention
on creating a productive workplace that keeps their employees
motivated. In fact, there’s widespread recognition among managers
that employee motivation is a critically important issue. Several
years ago, a survey of a large sample of U.S. managers on that very
subject found that:

o Eighty-five percent of managers believed that an employee’s
level of motivation has a significant impact on his or
her performance

o Seventy-nine percent of managers believed that motivating
employees is one of the most important functions they perform
as leaders

o Ninety-four percent of managers believed workforce motivation

was truly important to the success of the overall operation

o Eighty-two percent of managers believed that their behavior
had a significant impact on their employees’ level of motivation.

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o Two-thirds of managers believed that it is getting tougher to
motivate their employees.

• These findings suggest that although managers know they need to
motivate their workforces, a significant percentage of leaders are
struggling to figure out how to do it.

• It helps to have a straightforward definition of the word motivation :
“the level of inner drive and energy a person is willing to expend
on a given activity to satisfy an unmet need.” An important note is
that our inner drive can be greatly affected and shaped by the things
going on around us and the context in which we operate.

• It’s common to think of motivation as a factor that can be influenced
in isolation. Give someone the right incentive, the thinking goes, and
he or she will be motivated. It’s also common to think of motivation
as governing performance. On a gut level, we all tend to believe
that if people are motivated, they will work harder, and that when
people work harder, they perform better and deliver better results.
All those beliefs are accurate to a point, but they oversimplify what
is actually a much more complicated dynamic.

Key Motivational Practices

• Several years ago, a large-scale study of 60 high-performance
organizations revealed a pattern of key practices.

• First, each of the companies in the study took great care to make sure
that its employees had the requisite talent to compete successfully.
Talent may include innate ability, but in the workplace, a talented
employee is someone who brings valuable knowledge and skill
to a job. That’s important, because knowledge and skill can be
cultivated. The organizations focused on making sure that their
employees were well suited to their jobs, and they made systematic
training and development a large part of their corporate cultures.

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Lecture 41: The Motivation-Performance Connection

• Second, the companies focused on motivating their employees
in a methodical and holistic way. They got their employees to
understand their missions and the needs of their customers, so
the employees would see the importance of performing to a high
standard. They established clear goals and performance standards
for everyone, so the employees understood what was expected of
them. These companies designed each job in a fashion that fostered
employee decision making, participation, and empowerment to
ensure that all employees felt respected, valued, and invested in the
organization’s success.

• Finally, these organizations provided appropriate support for their
workforces. It was readily apparent that they worked hard to keep
their employees in the communication loop. They also set up systems
to remove performance barriers quickly and to solve problems that
could derail performance. In a nutshell, these companies didn’t just
focus on employee motivation; they created organizational climates
and cultures that brought out the best in people.

The Performance Equation

• The approach taken by these successful organizations was so
consistent that it could be expressed mathematically. That led
something that called the performance equation, which is:
performance =/(talent x motivation x support).

• What that means is that performance is a function or byproduct of
the interaction of talent, motivation, and support. All three parts of
the performance equation must be in place to avoid demotivating
people who are trying to get things done at work.

• What if an employee has talent and is highly motivated but doesn’t
receive the support she needs? In a fairly short period of time, she
will become frustrated and demotivated because she doesn’t have
the information and tools required to perform her job.

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• What if an employee the talent to do the job but is highly motivated
and has solid support? This employee might work hard, even
enthusiastically. But while doing so, he might damage a machine,
erase a database, offer clients bad advice, or destroy a customer
relationship, simply because he is not sure what to do.

• What if an employee has the appropriate level of talent and the
support she needs to be effective but is not motivated to work and do
a good job? Once more, performance will suffer. Intensive coaching
and feedback are probably in order. But the company should also
consider whether its work environment is really as supportive as it
seems; not every employee is motivated by the same things,

Strategies for Workplace Motivation

• What can you do to create a more motivating, high-performance
workplace? Consider the following strategies:

o Start by clarifying and communicating your mission and what
you stand for. If you really want to motivate people, help
them understand the bigger picture of what you are trying to
accomplish. Employees need to understand the “why” behind
the “what” that they are asked to do.

o Make getting to know your employees a priority. Understanding
their strengths and weaknesses, their wants and needs, and
their personalities and attitudes can be a real help in developing
tailor-made motivational strategies that bring out the best in
each person.

o Clarify performance expectations for everyone. Nearly all
current theories and models of motivation make a strong case
for clarifying focus and giving people a sense of achievement
and recognition. You need to create focus by helping employees
identify the goals and activities that are most important for
their success and that of your enterprise.

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Lecture 41: The Motivation-Performance Connection

o Properly equip people with the support they need for success.
If you want a high-performance workforce, remember
that a starting point is providing your employees with the
fundamentals necessary for success. When employees don’t
have the things they need to compete, you are automatically
building in workplace frustration and anger and creating
problems that distract people from delivering results.

o Empower employees to make decisions and share ownership
over what you are trying to accomplish and how you are trying
to do it. It’s well known that when people own something,
they treat it much better than if it belongs to someone else.
You would be well served to give your employees a sense of
ownership in your organization’s plans by engaging them in
planning, organizing, and decision making right out of the gate.

Develop the link between
performance and outcomes.
Organizations that do a
great job of clarifying goals
and expectations have the
built-in benefit of a solid
basis for rewarding good
performance and addressing
performance deficiencies.

One of the hallmarks of high-
performance organizations is
that leaders and coworkers
promote and encourage
teamwork and cooperation.

Promote teamwork and make work more interesting and fun.
From the start, build a solid leadership team around you with a
shared vision, then look for ways to promote cooperation and
teamwork throughout your
organization. In doing so,
you not only create a climate
for effective motivation,
but you also increase the
support component of the
performance equation.

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o Provide ongoing and balanced performance feedback and
coaching to everyone. Once you’ve established what people
will be held accountable for, it is critically important that you
and your fellow leaders make coaching a big part of your
operation. Feedback is a powerful motivator, and praise can
reinforce desired behaviors. At the same time, when people are
not performing well, they need to be told so in a constructive
way, with a game plan to help them get better.

o Be fair, forthright, and ethical in everything that you do. As
you strive to improve the performance of your operation,
work hard to ensure that fairness and transparency are
cornerstones of your approach. People want to see fairness
and equity applied to every part of your operation, including
workload, distribution of resources, enforcement of
workplace policies and rules, and of course, the rewards that
you distribute.

• A final piece of advice: Go to your computer, pick a search
engine, and type in “Best places to work in America.” Spend some
time looking at these great and productive places to work, and
use them to develop your vision for where you want to take your
own organization. You’ll find a wealth of creative and innovative
practices to help get you there. Keep the performance equation
in mind as you make plans for your organization and as you
tackle the performance problems that inevitably crop up along
the way.

Suggested Reading

Longenecker, Dwyer, and Stansfield, “The Human Side of Manufacturing
Improvement.”

Nelson, 1001 Ways to Reward Employees.

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Lecture 41: The Motivation-Performance Connection

Questions to Consider

1. In your opinion, what are the things that truly motivate people to do
their best work?

2. Conversely, what are the specific things that demotivate people at work?

3. What are the specific factors that affect a person’s potential for achieving
superior performance?

4. What needs to happen at your place of employment to create a more
productive workplace?

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Winning with Teamwork

Lecture 42

I t’s a premise of many economic theories that people seek to maximize
their own interests in any given situation, and that may well be true.
Unfortunately, though, people often fail to recognize that they can
serve their own interests best by cooperating with one another. Teamwork
and cooperation are absolutely essential in just about any work situation,
with rare exceptions. This lecture will examine the power of teamwork
and cooperation in an organization—and how you can foster them in your
own workplace.

Cooperation and Teamwork

• The word cooperation has been defined as “a willingness to work or
act together for a common purpose or benefit.” Notice two critical
elements in that definition: willingness and common purpose. When
people cooperate with one another, they demonstrate not only an
understanding that they share the same goal but a willingness to
work together to get there.

• The word teamwork , which dates back to the 1820s, is sometimes
used interchangeably with cooperation, but it’s actually a bit
different, it has been defined as “a cooperative and coordinated
effort on the part of people working together with a unifying cause
or goal.”

• To have teamwork, you must have cooperation. But the definition
makes it clear that the group’s activity is coordinated and that
the group members are unified by their common goal. Teamwork
takes cooperation up a notch; instead of just helping each other
out randomly or when needed, people who are engaged in
teamwork work together in a coordinated fashion and help each
other on an ongoing basis to accomplish a goal that binds their
interests together.

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Lecture 42: Winning with Teamwork

Like the pieces of a chess set, an effective team has individuals whose skills
complement each other's.

• The term teamwork, of course, is based on team, which just might
be one of the most overused words in organizational America. We
frequently refer to groups of people in our workplaces as teams,
using such phrases as “our executive team,” “our office team,”
“we’ve got a strong sales team,” or “our research team is very
productive.” But simply calling a group of people a team doesn’t
make them one.

• A team is a group of individuals with complementary skills and
roles who are committed to a common purpose and are accountable
to one another. The word dates back to the 9 th century, when the
English word feme, meaning “set of draft beasts,” was conjugated
with the Dutch word toom, meaning “bridle” or “reins.” A team is a
group of people whose efforts and energies are properly focused and
directed and who hold one another responsible for their individual
efforts as they pursue a collective goal or outcome. Note that the
word team also implies leadership; someone must focus, or bridle,
the team to direct it toward its objective.

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Building Teamwork in Difficult Circumstances

• When a work unit is made up of individuals who have strong
working relationships with the people they need in order to deliver
results, cooperation and teamwork become part of the organization’s
culture. Moreover, in such an environment, unwanted employee
turnover is lower, commitment to fellow workers is greater,
productivity is higher, and overall results are better.

• The fact remains, however, that it can be extremely hard to get
people with conflicting interests to overlook their differences and
work together toward a shared goal. But this has challenge been
accomplished—and under the most trying circumstances. There’s
no better example than that of the 16 th president of the United
States, Abraham Lincoln.

• In her remarkable book, A Team of Rivals, historian Doris Keams
Goodwin provides us with an amazing picture of how Lincoln and
his chief political adversaries came together to become an effective
leadership team that would later be recognized for saving the Union
during the American Civil War.

• On May 18, 1860, four rivals—-New York senator William H.
Seward, former Ohio senator and governor Salmon P. Chase, former
Missouri congressman Edward Bates, and Lincoln—waited for the
results of the Republican National Convention. This convention
would determine who would represent the party in the upcoming
presidential election.

• When Lincoln received the Republican nomination, his three rivals
were distressed, dismayed, and angry because each of them had
vigorously and ambitiously sought the presidency. But the new
president, from very humble beginnings himself, had an uncanny
knack for bringing people together and getting them to see his vision
of the future. Perhaps the best illustration of his leadership skills was
his critical and unprecedented decision, after winning the presidency,
to make his three eminent political rivals part of his cabinet.

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Lecture 42: Winning with Teamwork

• Seward became the secretary of state; Bates, the attorney general;
and Chase, the secretary of the treasury. To complete his selections,
Lincoln offered the three remaining cabinet seats to former
Democrats—that is, people of the party that opposed his election.
These men were powerful competitors to Lincoln, and some even
initially displayed open disdain for their new boss. Yet in fairly
short order, Lincoln’s skill as an emotionally intelligent leader
would win their respect.

• Goodwin’s account of Lincoln’s presidency provides us with an
outstanding case study in the skills leaders need to forge a group
of individuals into an effective team. Lincoln possessed the ability
to see the bigger picture and help others share that vision. He had
the capacity to focus on both the plan and the desired outcome and
the persistence to press onward, even in the face of disagreements,
setbacks, and personal tragedies, drawing upon his cabinet members
for guidance at every turn.

• Lincoln had the ability to form friendships and great working
relationships with the men who had previously disliked and
opposed him. He took responsibility for failures, shared credit when
things went well, and was quick to learn from his mistakes. Finally,
Lincoln had the ability to deal with strong egos with decency and
morality, and he communicated with compassion, honesty, humor,
and empathy for his listeners. By doing these things, Lincoln
was able to tap into and leverage the manifold talents, networks,
political savvy, and prodigious intellects of his team of rivals.

Critical Gateways to Cooperation and Teamwork

• A set of practices called the critical gateways to cooperation and
teamwork can help you enhance these areas in your organization.
These practices don’t cost much money, but they require patient
and persistent leadership.

• First, if you are serious about increasing workplace cooperation and
teamwork to achieve better performance, it is imperative that you
lead by example. You must demonstrate the behaviors that will help

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you become known as a team player. Keep in mind that if you’re
not a team player yourself, it will be exceptionally difficult for you
to build an effective team.

• Second, clarify your mission. The quickest way to get a group
of people to pull together is to develop consensus around your
overarching vision, your mission, and key goals that are necessary
for success. For example, President Lincoln used the clearly defined
mission of saving the Union as a rallying cry to help his people stay
focused on the big picture.

• Next, it’s critically important that people understand their roles and
what they need to do to make the workgroup successful. If you are
a football devotee, you know that successful plays depend on every
person performing his job correctly and knowing everyone else’s
job, as well.

• Critical behaviors and team-based norms are also essential for a
workgroup to become a fully functional team. We should expect
people to cooperate as a minimum requirement to work in any
organization. But once people cooperate, we can build on their
cooperative spirit. In Lincoln’s cabinet, it was acceptable to
disagree or to offer a different point of view. It was not acceptable
to lose your temper or disrespect others.

• Another element of building an effective team is increasing the
level of workplace participation and empowerment with the people
in your workgroup. This helps people begin to take ownership
over the things that are going on in an operation. As ownership of
activities increases, so do teamwork and commitment to both what
you’re trying to do and how you’re trying to do it.

• Savvy leaders also take advantage of team-building activities.
There are many models for team development. You can foster team
thinking through such events as off-site team-building retreats, where
team members learn how to communicate more effectively with one
another and develop action plans for performance improvement.

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Lecture 42: Winning with Teamwork

Another option is team-based training, where every member of the
team is exposed to the same concepts and curriculum, which gives
people common knowledge and a common language.

• Finally, it is important to implement team-based performance
measurement, feedback, and reward systems. When the performance
of a workgroup or team is measured and this information is fed
back to the group on an ongoing basis, the process not only unites
individuals but improves group cohesiveness and performance,
o With regard to rewards, make a point of rewarding teams rather
than just the individuals on the teams. A substantial body of
research makes it very clear that team-based rewards can go
a long way toward forging stronger levels of commitment,
cooperation, and teamwork.

o Further, if your organization measures team performance,
it becomes easy and natural to celebrate team success—and
celebrating team success is a surefire way to get people more
excited about working together.

Suggested Reading

Goodwin, Team of Rivals.

Lencioni, The Five Dysfunctions of a Team.

Questions to Consider

1. Think of a time in your life when you felt as if you were part of a
team that was getting great results. What was it that made this team so
effective, and what are the lessons you learned from this experience?

2. Conversely, think of a time in your life when you were part of a group
that never became a team and that struggled with performance. What
was it that made this group so ineffective, and what are the lessons from
this experience?

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3. What specific things do you believe need to happen to improve the level
of teamwork and cooperation among the people you work with?

4. Are you viewed as a team player by the people you work with?
If not, what are the costs associated with not working well in a
team environment?

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Lecture 43: Coaching—From Gridiron to Boardroom

Coaching—From Gridiron to Boardroom

Lecture 43

W hen leaders in any organization take coaching seriously, good
results inevitably follow. Coaching can help people get and stay
focused, learn and develop more quickly, and increase their level
of effort. But it’s important to keep in mind that not all coaching is good
coaching—certain practices can be counterproductive if they alienate or
discourage employees. This lecture will make a case for the importance of
good coaching, provide examples of good coaching, and discuss the reasons
that tailor-made coaching in particular works.

Pat’s Problem

• To understand the importance of coaching, let’s look at a case study
with a manager named Pat who was confronted with a significant
performance challenge. Pat’s boss had warned him that performance
goals for the next year were being cranked lip—with no additional
resources to help.

• Pat knew that hitting aggressive goals was going to be tough, and he
felt overwhelmed. He had already used a computer upgrade and a
process improvement to get better perfonnance from his employees
during the previous two years.

• After doing some research, Pat concluded that performance
improvement could come from coaching. When Pat looked at his
department’s roster with a critical eye and saw that a number of
people needed to step up their performance, he realized he needed
to make developing his staff a priority.

Effective Coaching

• Research shows that Pat was on to something: A survey of U.S.
business leaders revealed that they overwhelmingly realize the
importance of coaching. Eighty-two percent of the sample stated
that effective coaching was critical to their success. An even larger

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portion of the sample, fully 93% of the participants, believed that
employees wanted and needed coaching. Furthermore, 74% asserted
that most employees do not get enough feedback and coaching.

• The business leaders demonstrated some sensitivity to the demands of
good coaching: 68% of them believed that it was critically important
to know their employees, and 78% believed that it was extremely
important to understand an employee’s ability and motivation.

• But the most telling result of the survey was the following: 80% of
the business leaders in the sample believed that their coaching skills
needed improvement, and a full 66% stated that they struggled to
make the time for coaching.

Pat’s Solution

• Let’s walk through the coaching process that Pat used to improve
the performance of his workgroup. To start with, Pat did a couple
of online assessments, read a series of coaching articles, and went
to a one-day coaching seminar. He also signed up for once-a-week
coaching sessions with a consultant. Pat was smart enough to
realize that he needed ongoing feedback and accountability to help
change his own behavior.

• Pat identified specific behaviors that he needed to model for his
team to let his employees know that he was serious about change.
He realized that he needed to work on his punctuality, keep his desk
a little more organized, and follow up on verbal commitments. He
also needed to run better meetings.

• Next, Pat clearly defined winning for his team. Once his company’s
goals for the upcoming year had been finalized, Pat identified a
scorecard of specific performance metrics against which department
performance would be measured. Pat’s department had always had
goals, but in the past, Pat had formally shared them only with the
people in his immediate workgroup. Now everyone in the entire
department would know exactly what was expected of the group as
a work unit.

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Lecture 43: Coaching—From Gridiron to Boardroom

• At this point, Pat decided that his team goals needed to be
translated into individual goals; thus, he went through a formalized
performance planning cycle with each of his employees. Pat asked
his employees to prepare descriptions of their key responsibilities
and activities and to take a first shot at setting goals in each of
their performance areas. He then met one-on-one with each of his
employees and discussed and formalized each employee’s actual
role, goals, and value-added responsibilities for the upcoming
performance period.

• The meetings clarified for everyone the expectations and standards
they needed to meet and gave Pat a chance to describe what success
would look like for both the department and for the employees as
individuals. The result was that his employees came away with a
full understanding of what they needed to do to meet their new and
more demanding departmental goals.

• In the final piece of his performance planning process, Pat focused
on the important issue of support. He asked his direct reports what
they needed from him to be successful. Pat was actually using the
performance equation—performance = /(talent x motivation x
support)—to make sure that each of his employees was equipped
to succeed.

Going Forward

• At the end of the performance planning process, Pat and his staff
were more clearly focused on what they had to do, both as a group
and individually, in order to be successful. But once Pat and his
direct reports agreed on performance expectations and the new
performance period began, it was critically important for Pat to take
the time to monitor and track the ongoing performance of each of
his employees.

• Results-oriented leaders know that without accurate and up-to-date
information on an employee’s actual contribution to the organization,
coaching can become ill-informed guesswork that doesn’t achieve
valuable results and may even harm an employee’s performance.

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If you don't understand an employee’s role in an organization, coaching can
become ill-informed guesswork.

• Pat spent time observing and monitoring his employees’ activities,
as well as their output. Pat’s actions helped his employees
maintain their focus. At the same time, he reinforced appropriate
behavior and was able to take corrective action when things were
not going well.

• Pat was careful to observe both his employees’ behavior and their
performance at the individual and group level. And he made a point
of managing by walking around to stay connected to his employees
and observe their interactions with customers and other stakeholders.

Coaching on the Individual Level

• A truly effective coach needs to become proficient at tailor-making
a feedback and support strategy for each specific employee. The
way to do that is to understand each employee’s level of talent and
motivation. Based on the interaction of these two important factors,
research has identified four different kinds of employees: dream
employees, up-and-coming employees, underachieving employees,
and change-or-go employees.

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1 AndreyPopov/iStock/Thinkstock.

Lecture 43: Coaching—From Gridiron to Boardroom

• Dream employees are highly skilled and highly motivated; they
are one of any operation’s best resources for getting better results.
If you’re working with dream employees, you need to think about
your coaching role as being that of a nurturer. That is to say, as a
leader, you need to identify new and challenging job assignments
for your dream employees, provide them with regular doses of
praise and recognition, offer additional responsibility, and empower
them with additional decision-making authority.

• Up-and-coming employees are willing to work hard but may lack
some of the specific skills and talents they need. To be effective
in coaching them, you need to be both a teacher and a trainer. You
need to observe their performance to identify the specific skills
gaps that they have, then create meaningful training plans to help
them acquire the talent they need for success. The goal is to do
whatever it takes to help these employees become more proficient
in the skills they need for better performance as quickly as possible.

• The next category, underachieving employees, will put your
coaching skills to the test. Employees in this category typically
have the skills, expertise, and the talent they need to do good work,
but they’re low on motivation; that deficit tends to prevent them
from producing better results. To coach these employees, you need
to be a motivator. You need to take even greater care to clearly
establish performance goals and standards to create a greater sense
of employee performance ownership. When you see underachievers
engaging in desired behavior, be sure to reinforce it. But be willing
to use constructive criticism, reprimands, and even negative
consequences to move their performance in the right direction.

• Change-or-go employees are the toughest category. They not only
lack motivation, but they don’t have the ability or requisite skills to
do their jobs. Coaching employees of this kind requires reviewing
their employment records, tracking their performance, and ensuring
that they have the proper tools and support to be successful. Then,
it’s imperative to clearly define in writing all performance changes

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that the employee must make. You need to give the employee every
opportunity to succeed, while making it clear that a failure to do so
means termination.

o Once this plan is in place, be sure to monitor the employee’s
performance on a daily basis, providing ongoing feedback and
documenting the employee’s actual contribution.

o It’s important to keep in mind that change-or-go employees
are capable of turnarounds when they’re properly coached
and when they’re confronted with the harsh consequences
of nonperformance and failure to improve. But when the
employee is not responding to attempts to foster improvement,
your role as coach needs to shift to that of a disciplinarian
and documenter. You need to formally prepare for employee
demotion or termination.

o Although it’s always painful to see someone lose his or her job,
if employees in your operation are underperforming, you have
a moral and social responsibility to strongly address the issue.
Make sure your human resources department is a partner in
this action.

Pat’s Conclusion

• Let’s return to Pat’s story and see how he did in coaching his own
people. Pat made monthly one-on-one meetings part of his coaching
modus operandi with great success. The collective performance of
his department improved, and Pat’s team met the company’s goals.

• Here’s a look back at what Pat did to improve performance in
his department:

o First, he realized the importance of coaching and feedback in
developing his employees’ talents.

o Next, he assessed his own strengths and weaknesses and
took steps to acquire the skills and support he needed to be a
successful coach.

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Lecture 43: Coaching—From Gridiron to Boardroom

o Then, he clearly defined winning for his team, blit equally as
important, he used a performance planning process to define
what each person needed to do for the team to be successful.

o Finally, Pat developed a tailor-made coaching strategy for
each of his employees to provide the feedback, motivation,
development experiences, and accountability to maximize
individual performance.

• In 12 months, Pat became a better leader and a great coach. It
all happened simply because he needed to get better results and
was willing to take real action to do so. In the end, Pat was very
coachable himself—and that made everything else possible.

Suggested Reading

Longenecker, “Coaching for Better Results.”

Longenecker and Neubert, “The Practices of Effective Managerial Coaches.”

Questions to Consider

1. If you are in a leadership position, are you comfortable providing
ongoing and balanced performance feedback to your employees?

2. Do you tailor-make your coaching strategy to the needs of each
individual employee and his or her current level of performance?

3. Do you take sufficient time on a regular basis to meet with your employees
on an individual basis to reinforce effective and desired behaviors?

4. Do you take sufficient time on a regular basis to meet with your
employees who might be struggling or who need corrective action to get
their performance back on track?

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Understanding Power Relationships

Lecture 44

W orkplace power, authority, and influence shape the landscape of
virtually every organization on the planet. Yet when it comes to
these factors, people make three common mistakes: (1) failing
to understand the fonnal authority and power attached to their current
positions at work, (2) failing to take proactive steps to increase their personal
influence, and (3) failing to effectively manage their working relationships
with their supervisors. In this lecture, we will examine these issues to enable
you to avoid these kinds of mistakes.

Power and Influence

• Power has many definitions, but a person or group has power when
they possess the capacity to exert influence or control over the
actions of others. They typically possess something that someone
else desires.

• Influence, in contrast,
is power in action.
Influence is the effect that
a person or workgroup’s
actions have on the
actual attitudes, beliefs,
and actions of others.

• Although power is the
capacity to affect others,
influence can be thought
of as the extent to which

A high-ranking executive might have
great power, but if it’s not used effectively,
his or her influence will be limited.

• When we think about power, we frequently think about presidents,
kings, CEOs, military leaders, and the like. But the truth of the
matter is that we all possess some degree of power that is attached
to our current position.

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Lecture 44: Understanding Power Relationships

power is actually being put into use to affects others. For example,
although the president of an organization may have a great deal of
power, his or her ability to influence a particular employee’s daily
behavior might actually be quite limited.

• Power and influence are critical to any study of organizational
behavior. And most people are absolutely fascinated by this topic—
it’s human nature.

Types of Power

• In 1959, researchers John French, Jr., and Bertrand Raven developed
a classification of the bases of power. They identified five basic
types of power: legitimate, reward, coercive, expert, and referent.

o Legitimate power is the formal authority granted to people
by their organizations because of their formal positions. Our
supervisors have legitimate authority over us to assign work,
review our performance, grant us decision-making power,
and enforce company policies because of their position in our
organization’s chain of command. There is also legitimate
power attached to the position that you hold.

o Reward power is a person’s ability to provide others with
rewards, incentives, or inducements to influence their behavior.
A leader’s control of budgets, pay raises, bonuses, and
promotional opportunities can have a powerful impact on the
behavior of others when properly applied.

o Coercive power is the opposite of reward power. People who
possess coercive power in the workplace can influence others
through the use of sanctions, punishment, and reprimands or by
removing benefits or resources.

o Expert power results from a person’s special knowledge or skill
that is prized and needed by others. If you’re an expert, people
will be willing to follow your lead because of the knowledge
you possess, your ability to solve problems, and your ability to
make sound decisions.

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o Referent power refers to the potential influence that a person
can have over others through strength of personality. It derives
from our ability to connect with people and to forge strong and
effective working relationships with them.

• The first three sources of power—legitimate, reward, and
coercive—are collectively known as position power, because they
are clearly tied to the position that a person holds in an enterprise.
Let’s apply that information to try to avoid the first common
workplace mistake described earlier—not understanding the formal
power of your current position. Consider these questions:

o Have you taken the time to assess how much legitimate power
and authority are attached to your position?

o Have you determined the things you control, the decisions you
can make, and the actions you can take of your own accord?

o If you are in a leadership position, are you making full use of
the rewards and resources you possess that can influence the
behavior of others in positive ways?

o Have you taken stock of the potential sanctions you have at
your disposal to shape the behavior of the people reporting
to you?

• The last two bases of power—expert and referent—fall under the
category of personal power. Personal power is power that is tied
back to what you know and who you really are as a person. An
understanding of personal power can help you avoid the second
common workplace mistake: failing to take proactive steps to
increase this type of power.

Increasing Your Power

• As mentioned, it’s important to know and understand the position
power that you possess in your current job. You need to know
what you have to work with and the boundaries that you must
operate within.

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Lecture 44: Understanding Power Relationships

• However, be careful not to make your position power the sole
basis for getting work done because people will soon lose respect
for someone who has no basis for power other than his or her title.
Similarly, the use of reward and coercive power can make people
compliant, but it doesn’t necessarily translate into people being
committed to what you are trying to accomplish.

• That’s why it’s imperative to develop your professional and
technical expertise. People acquire power when they possess
needed skills and information. Becoming an expert in areas that are
critical to your organization’s success is a surefire way to increase
your organizational influence.

• Connections help, as well. You can increase your power by
developing 360-degree working relationships, building strong
teams, and creating strong social networks both within your
organization and across your industry.

• Creating and building on a referent power base is something that
most people can do if they are willing to make it a priority. Simple
yet powerful people practices, such as making sure to learn and
remember people’s names, can go far.

Understanding Your Boss

• Let’s discuss the third common workplace mistake: failing to
effectively influence and manage your relationship with your
supervisor. Research shows that people are generally quick to assess
working relationships with their peers and subordinates, but they
often fail to see the value in assessing their working relationship
with the boss.

• Taking the time to understand what is working well and what needs
work is an important first step toward better managing your boss.
Here are some important questions to guide your assessment:

o What does your boss do that helps your productivity?

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o What does your boss do that hurts your productivity?

o What do you need from your boss that you are not getting?

o What specific things are needed to improve the overall quality
of your working relationship?

• Answering these questions will give you a starting point for
developing your improvement plan to better influence your boss.
Next, work hard to get to know and understand your boss. The two
of you are linked together—whether you like it or not; thus, it’s
important to pay attention to how he or she operates. Think about
such questions as:

o What motivates your boss?

o What are your boss’s likes and dislikes?
o How emotionally intelligent is your boss?

• Next, try to put yourself in your boss’s shoes. Find out his or
her performance goals and organizational expectations. When
you know that your boss has overly aggressive goals to meet, an
overwhelming workload, resource shortages, unrealistic timelines,
or perhaps even his or her own bad boss, you can be more
empathetic and offer the right kind of help.

Managing Your Boss

• Once you better understand your boss, several practices can help
you improve the relationship. One such practice is to under¬
promise and over-deliver. Most bosses appreciate when their
employees exceed expectations. When you deliver what your boss
expects on an ongoing basis—or better yet, even more than your
boss expects—you establish your credibility as someone your boss
can depend on.

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Lecture 44: Understanding Power Relationships

• It is also important to learn how to communicate effectively with
your boss. Most bosses have a preferred style of communication.
Some do all the talking, others listen, and others prefer reading.
Most bosses also have a preferred channel for communicating. The
important point is that you understand how to proactively interact
with your boss in a fashion that he or she prefers.

• Take the initiative to make alignment sessions with your boss a
regular occurrence, both to help you stay on track and to maintain
your boss’s coaching. Schedule short, 15-minute meetings with your
boss once or twice a month to keep the channels of communication
open. Use the sessions to discuss your performance and what you
are working on and to solicit your boss’s input.

• Never identify a problem or bring a complaint to your boss without
having a potential solution in hand. Most of our bosses have a fair
number of problems and issues on their plates on any given day, so
don’t be surprised if you get a less than warm reception when you
go to your boss with yet another problem or difficulty. If there is an
issue that you need to bring to your boss’s attention, make sure that
you properly frame it and get all the facts. Then, take the time to
offer up your ideas or your potential solution to the difficulty.

• Finally, it is important to always show respect for your boss. Don’t
engage in gossip or backbiting. Other people are watching and
listening. When word of bad-mannered behavior gets back to the
boss, it can spell career disaster for the backstabber. It also causes
other people to wonder what you might say about them when they
are not around.

• In spite of all this advice, remember that, as a subordinate, there’s
only so much you can do to change your boss. If your boss puts you
in a place where coming to work is more stressful and unproductive
than it should be, then it might be time to consider leaving. But for
most of us, taking proactive steps to help our bosses help us is a
good move.

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Suggested Reading

Cross and Parker, The Hidden Power of Social Networks.
Greenberg and Baron, Behavior in Organizations.

Questions to Consider

1. Have you taken the time to detennine how much influence you actually
have at work?

2. Do you understand the specific things you can do to increase your power
and influence at work?

3. Have you taken the time to identify the specific behaviors and practices
that represent “professionalism” in your current position?

4. Have you thought through and developed a plan to appropriately
influence your boss in ways that will help you get your work done?

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Lecture 45: Handling Workplace Conflict

Handling Workplace Conflict

Lecture 45

W hether we like it or not, conflict is an inevitable part of
organizational life. If you’re in a leadership position or if you
aspire to a leadership role, a great deal of your success will
depend on how well you respond to and manage conflict among the people
you work with. This lecture will discuss where conflict comes from and the
areas in which it manifests itself. Then, we’ll conclude by looking at a model
to help deal with conflict.

Rising Workplace Conflict

• In a recent survey of American business leaders and other
professionals, nearly 70% of the respondents said they believe that
conflict in the workplace is on the rise. The respondents identified
several reasons for this increase.

• First, there’s the pressure factor. As organizations experience
greater competitive pressure, the respondents said that they are
constantly being asked to change, to do more with less, and to
do everything faster. As jobs change, workloads increase, and the
paces of people’s personal lives accelerate, they have more pressure
and stress. With more pressure and stress, our communication and
coping skills can break down, making us bad-tempered.

• Then, there’s the complexity and change factor. As organizations
grow in size, they increase in complexity. The respondents said
that it’s becoming a greater challenge to have a shared vision and
strategy understood by all, clearly defined roles and responsibilities,
and high levels of teamwork and cooperation.

• Another major source of conflict is the competition factor. The
respondents said that as their organizations experience rising
external competitive pressure, they also experience an increase

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in internal competition. When people are competing for scarce
resources, such as budget allocations, rewards, and promotions,
healthy competition can easily degenerate into open conflict.

• The leadership factor also plays a role in conflict. As their
organizations become more complex and competitive, the
respondents reported, there is a rising need for dynamic leaders to
step up and realign their leadership skills to meet the challenge. But
many individuals are not practicing the fundamentals of leadership
in their rapidly changing organizations, and the natural result is
unnecessary and counterproductive conflict.

• Finally, there is the social factor. The respondents reported a greater
range of workplace attitudes, values, and personalities that increase
the likelihood of interpersonal tension and conflict at work. Society
is changing, and it’s inevitable that the workplace will change with
it. If those changes produce tensions in society at large, they will
undoubtedly appear the workplace, as well.

Types and Levels of Conflict

• There are two primary types of conflict: substantive or task-based
conflict and emotional or affective conflict.

• Substantive or task-based conflict exists when individuals and
groups have differences of opinion. They may differ over such
issues as facts, goals, strategies, plans, policies, processes, roles,
resource allocation, or decision making. A conflict is substantive
when the issues driving the disagreement are tangible, material, and
reasonably concrete. Selecting a new software vendor or developing
the budget for a project are both substantive issues.

• Some substantive conflict may be inevitable at times. These types of
conflict can be beneficial if people are focused on sharing their ideas
and opinions so that they can get at both the truth and the best solution
to a problem or disagreement. But these differences of opinion can

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Lecture 45: Handling Workplace Conflict

escalate into tense arguments if not properly managed. When this
happens, unchecked conflict over issues of substance can damage
and even destroy working relationships, teamwork, and careers.

• Handling substantive conflict is all the more challenging because
of the other kind of conflict: emotional or affective conflict. This
type of conflict exists when there is tension between people because
of personality differences or a breakdown in an interpersonal
relationship. It’s just as inevitable as substantive conflict, but it’s
much more volatile. You need to take special care to identify it and
take action to minimize it.

• To make matters even more complicated, conflict within any
organization can break out at several different levels: intergroup,
intragroup, and interpersonal.

o Intergroup conflict exists when a struggle takes place between
groups, teams, departments, or even different operations within
the same organization.

o Intragroup conflict exists when there is conflict within a
workgroup or team. It is not uncommon to see a workgroup or
team fracture and split up into subgroups.

o Interpersonal conflict exists
when two people are caught
up in a skirmish over work
or even over a non-work-
related issue. This type of
conflict is often at the root
of other forms of conflict.

• It is important to remember that
conflicts can be substantive,
emotional, or both at all three
of these levels, with each
level presenting its own set
of challenges.

Interpersonal conflict occurs
between two people and can
happen for work-related or non
work-related reasons.

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Preventing and Handling Conflict

• Without effective leadership, virtually any substantive issue in an
organization can become a conflict. What steps can you take to avoid
unnecessary workplace conflict and better handle it when it occurs?

• First, it’s imperative to create individual role clarity to ensure that
all employees understand their job responsibilities and authority
and who they report to in the organization structure. This clarity can
go a long way to help prevent conflicts over these important issues
and can have a powerful impact on motivation and teamwork.

• Next, make it acceptable for people to have and express legitimate
differences of opinion, especially when discussing substantive
issues in the workplace. Encourage people to be open and candid
when they’re talking about setting goals, developing plans,
improving processes, solving problems, or discussing any issue that
is important to your operation’s success.

• You also need to work hard to know, understand, and address the
problems that confront your workgroup because of organizational
policies, procedures, and practices. In many organizations,
ineffective and outdated modes of operation can create real
difficulty for people trying to get their work done.

• Another essential task is to train yourself and the people you work
with to develop good problem-solving and conflict resolution skills.
It is useful when members of a workgroup or team have an agreed-
upon problem-solving process and conflict resolution model that
they can all use when needed.

• F inally, it is critically important that you know yourself and how you
handle and work to resolve conflict. Do you know your strengths
and weaknesses in handling workplace conflict? Do you know
and understand how your actions can affect others when resolving
conflict? Do you know your preferred style of resolving conflict?
You need that kind of self-awareness if you are to successfully turn
workplace disagreements into positive outcomes.

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Lecture 45: Handling Workplace Conflict

The Thomas-Kilmann Conflict Resolution Model

• Since 1974, the Thomas-Kilmann conflict resolution model has
helped many people understand the various strategies that can be
used to resolve conflicts—whether they are parties to a conflict
themselves or observers trying to resolve a conflict among others.

• Developed by management professors Kenneth Thomas and Ralph
Kilmann, the model focuses on the interaction of two critical
behaviors: assertiveness and cooperation. Assertiveness can be
described as the strength of a person’s desire to satisfy his or her own
concerns and needs in pursuing a desired outcome. Cooperation,
in contrast, is a person’s willingness to satisfy the concerns and
needs of others involved in the conflict who are pursuing their own
desired outcomes.

• The interaction of these two variables creates five conflict-resolution
strategies: competition, accommodation, avoidance, compromise,
and collaboration.

o The competition approach is high on assertiveness and low on
cooperation. With this strategy, a person in a conflict pursues
his or her own concerns in a fairly aggressive fashion and often
does so at the expense of other people involved in the conflict.
The problem with using the competition or forcing approach is
that the conflict results in a winner and a loser.

o In contrast, accommodation is a style in which a person
is unassertive and willing to be highly cooperative. Here,
individuals give lower priority to their own needs and concerns
to satisfy the needs and concerns of others. But over time,
having unmet needs has a degrading effect on performance, job
satisfaction, and attitude.

o An avoidance strategy means that a person is both unassertive
and uncooperative when it comes to attempting to resolve a
conflict. The avoidance approach suggests that a person shuns
conflict at all costs and is willing to ignore or disengage from

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an issue regardless of its importance. The warning attached to
an avoidance strategy goes back to the simple fact that most
problems, conflicts, and crises do not go away without action.

o A compromising strategy takes a moderate position on the
issues of assertiveness and cooperation. When people take a
compromising approach, it means that they are willing to take
steps to find a mutually acceptable solution. But the warning
here, especially in the case of a substantive business conflict,
is that a compromise solution to a problem might not be a real
solution at all. It may just put off the underlying conflict for
another day.

o Finally, there’s the collaboration strategy, which makes a
tremendous amount of sense in most business scenarios. When
people collaborate to resolve a conflict, they explore the actual
disagreement to solicit insight from one another. Clearly,
if you’re trying to resolve a conflict between others, this is
the ideal scenario. But this strategy takes more time, more
patience, and more effort than all of the other tactics—which
can be challenging in some situations.

• The real benefit of the Thomas-Kilmann model is that you can use
its five approaches to analyze any workplace conflict you see or are
involved in, then decide how you can best respond to it. The next
time a workplace conflict occurs, start by determining whether it
is substantive or emotional and at what level the conflict is taking
place (intergroup, intragroup, or interpersonal). Then, determine
the levels of cooperation and assertiveness of the parties. You can
then use the five resolution strategies to determine how you will
approach the conflict.

Suggested Reading

Bazerman and Neile, Negotiating Rationally.
Yourdon, Death March.

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Lecture 45: Handling Workplace Conflict

Questions to Consider

1. What are the primary causes of the conflicts that you experience
at work?

2. How does workplace conflict affect your ability to get your work done?

3. When you are confronted with a conflict at work, how do you respond?
Do you understand your strengths and weaknesses in resolving conflict?

4. When you are confronted with a conflict, do you have a systematic
approach to resolve or alleviate it?

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Ethics and the Bathsheba Syndrome

Lecture 46

E nron, Tyco International, Arthur Anderson, Global Crossing, Adelphi
Communications, Bear Stearns—these company names have become
synonymous with scandal. In each of these cases, corporate leaders
created company cultures that were driven by exceptionally unethical
behavior. News headlines today reveal unethical business behavior still
goes on en masse. Even in organizations with strong ethical guidelines,
temptations can lead employees to immoral decisions. This lecture will
examine where those temptations come from and close with some strategies
to protect yourself and your coworkers from them.

The Practicality of Ethics

• Business school discussions of ethics have a way of becoming
abstract and philosophical. But in the business world, ethics are
realistic and practical because good ethics are good for business
and for your career.

• There is a well-established link between an organization’s ethical
behavior and its financial performance. Although there might be
short-term financial gain to be had by cheating, over the long run,
ethical behavior delivers better financials.

• Having a reputation as an ethically responsible enterprise makes it
easier to retain and attract customers because most people want to
do business with an organization that they can trust and believe in.

• Organizations that create ethical and trusting cultures have higher
levels of teamwork and more effective communications. This makes
it easier and faster to drive organizational change and transformation,
which can be a real competitive advantage in most industries.

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Lecture 46: Ethics and the Bathsheba Syndrome

• In the current talent wars, organizations that act in socially
and ethically responsible ways have a leg up on attracting and
retaining top talent. Organizations that frequently show up on lists
of America’s most ethical companies are not only doing the right
thing, but they are great places to work and very profitable, high-
performance operations.

The Origins of Ethics

• The starting point for ethical decision making is our moral values,
that is, our fundamental beliefs concerning what is good or bad,
right or wrong, and acceptable or unacceptable. Our moral values
are molded to a great extent by our religious beliefs, our training,
and the influence of our families and home environment, especially
during our developmental years.

• Moral values are critically important because they become the basis
for our personal ethics, which are the standards or codes of conduct
that guide our decision making and behavior. Stated differently,
our ethics represent our personal beliefs about whether an action or
decision is right or wrong.

• Your personal ethics might address such issues as your stance on
honesty and lying, the use of confidential information, and whether
it’s acceptable to use alcohol or drugs.

Dealing with Ethical Issues

• When ethical issues are in play, your first action should be to stop
and think. Then, gather relevant information and facts so that you
fully understand both the situation and the context of the decision
that needs to be made.

• Next, make a list for yourself of the options that are open to you.
Ask: Is there really no alternative other than making a questionable
choice? Have you considered every possible course of action?

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• Then, you need to clearly identify the legal and ethical implications
of each course of action in your decision-making options. This
requires that you consider all the stakeholders that are affected by
each alternative and the consequences of the various options.

• You also need to make sure that you consider unintended
consequences in your deliberation. What if your decisions don’t
turn out as planned?

• It is essential to ask the following questions when making decisions:
o Is this decision legal?

o Is this decision in line with
my organization’s values?

o Is this decision in line with

my own values?

o How will this decision affect
the stakeholders?

o What are the upside and
downside of this decision?

• Bear in mind that the answer to
an ethical dilemma might have
already been made for you. If you
look at your organization’s code
of conduct, union contract, or policy manual, you may find that
some decisions have already been preprogrammed.

One test to see if an action is
ethical is to consider its legality.

• Next, seek wise counsel and the input of knowledgeable and
experienced people whom you trust when making decisions
involving ethical issues. There is no substitute for getting a second
opinion to test your thinking and approach in making a decision
with serious ethical consequences.

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Ingram Publishing/Thinkstock.

Lecture 46: Ethics and the Bathsheba Syndrome

• Finally, when making a decision with ethical implications, ask
yourself: What would our board of directors or my mom have to
say about this decision when they find out about it? Pay attention to
your instincts.

“I Don’t Know What I Was Thinking”

• Though it’s easy to outline a guide for thinking your way through
ethical decision making, in the moment, it may not be so simple.
Think about how often you see people in the news who’ve been
caught behaving unethically and consider how often you hear
them say, “I don’t know what I was thinking!” Thinking your way
through an ethical dilemma isn’t always easy, and the temptations
to cross the line can be surprisingly strong.

• Asa general rule, organizations work hard to hire principled people,
and most people who work in organizational America are basically
ethical people. But the unsettling fact remains that any one of us
could get caught up in doing wrongful, unethical, immoral, and
even illegal things if we are not vigilant.

• This statement is exemplified by something called the Bathsheba
syndrome. To understand this principle, we must go back to
antiquity and take a look into the life of Israel’s King David,
an important figure to members of the Jewish, Christian, and
Islamic faiths.

o David had early success and enjoyed a career of exceptional,
principled, faith-based behavior.

o But he eventually made unethical decisions. First, he stayed at
home during a time of war, and second, he committed adultery
with Bathsheba. This cost him dearly.

o Bathsheba became pregnant, and though David attempted
a cover-up, his actions were eventually made known by a
whistleblower named Nathan. Then, a series of troubling events
rocked both King David’s personal world and his kingdom.

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• David took his eye off his job and made decisions based on what he
wanted, not what was best for his kingdom. He should have been at
the front with his army, not living a comfortable life at the palace. His
position as king exposed him to temptation and enabled him to act on
it in a way that otherwise would not have been available to him.

• Additionally, David mistakenly believed that he had the power to
cover up his wrongdoing—just as the executives at Enron, Global
Crossing, and Bear Sterns believed.

• Every position we ever hold over the course of our careers will
bring with it specific temptations—specific Bathshebas. We need to
handle them appropriately if we are to avoid ethical failure.

Protecting Your Ethics

• Though temptations abound, research with focus groups has
revealed some specific actions you can take to stay on solid ethical
ground. You can use these for yourself, but you could undertake
most of them for a department or team, as well.

• To start, develop a list of the various ethical temptations that
you face in your current work position. This process is called
temptation mapping, which means taking the time to specifically
identify the Bathshebas that confront you in your current position.
Temptation-mapping exercises with business leaders consistently
uncover common workplace temptations, including falsifying data,
abusing an expense account or corporate credit card, engaging
in inappropriate sexual relationships, stealing, and offering or
accepting bribes.

• Once you know what you’re up against, develop your situational
awareness. The purpose of this step is to avoid putting yourself in
circumstances where you will be exposed to harmful temptations
and prone to act on them. If King David had had better situational
awareness regarding his temptations, he might not have stayed in
his palace while his army was off at war—and he certainly wouldn’t
have invited Bathsheba to stop by for a visit.

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Lecture 46: Ethics and the Bathsheba Syndrome

• Another important guideline is to make yourself accountable. It
is critically important to foster both personal and professional
accountability with a person strong and honest enough to be your
mentor, friend, and watchdog. Many people, especially senior
leaders, get caught up in wrongdoing at a time in their lives or
careers when they are experiencing a sense of isolation and lack
real friends that they can count on. When confronted with an ethical
trial or dilemma, immediately tell a trusted confidante.

• Another important way of protecting yourself from the temptation
to behave unethically is to keep your financial, physical, and
emotional houses in order. Doing so will make you less susceptible
to the lures of greed, jealousy, addiction, or lust.

• Here’s another tip: Beware of the trap of being emotionally
expansive. A good psychologist will tell you that people who are
emotionally expansive feel that whatever they have is never good
enough. They always want more of everything, without appreciating
what they already have. We can all relate to this to some degree; on
any given day, we may wish we had a new car, a promotion, or a
better home. But if we think this way all the time, we are destined to
be in a constant state of frustration over what we don’t have instead
of being thankful and appreciative for what we do have.

• Finally, when making a decision about whether to do something you
consider to be in a gray area, questionable, or even flat-out wrong,
ask yourself this critically important question: What are the long¬
term consequences of this decision to my character, profession,
career, and family when others find out about my actions? The odds
are that people will find out.

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Suggested Reading

Blanchard, Leading at a Higher Level.

Ludwig and Longenecker, “The Bathsheba Syndrome.”

Questions to Consider

1. Think of a successful leader you have worked with during your career
who had a major ethical failure. What was the failure, how did it affect
the leader’s career, how did it affect your view of this person as a leader,
and what do you believe was the cause of the failure?

2. Have you taken the time to identify the specific ethical, moral, and legal
temptations that are attached the current position you hold?

3. Have you developed personal guidelines that will prevent you from
getting caught up in these temptations?

4. What specific things do you believe you need to do to maintain your
ethical compass?

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Lecture 47: Leading Real Organizational Change

Leading Real Organizational Change

Lecture 47

M any organizations faced with grave threats keep behaving the same
way that produced their problems in the first place. They just keep
doing what they’ve been doing, hoping that their problems will
go away. But change within an organization is unavoidable and essential.
Anyone who holds a leadership position in an organization, or hopes to
someday hold one, absolutely must learn how to get people to change the
way they do things. In this lecture, we’ll look at some research and ideas
about organizational change that will help you make it happen.

Drivers of Change

• Today, organizational change is driven by such factors as new
growth strategies, international expansions, business downturns,
mergers and acquisitions, and retrenchment strategies. These
strategic choices and events can require a wide variety of changes,
including major restructurings, workforce reductions, new reporting
relationships, the opening and closing of facilities, more aggressive
goals, and cost-containment initiatives.

• Technological advances are also a tremendous driver of change. As
new, speedy technologies make even newer, speedier technologies
possible, companies need to reorganize themselves constantly to
react or take advantage of new opportunities.

• As soon as your company changes, its competitors will adapt in
order to keep up, which will force your company to change yet
again. Today’s business environment is relentlessly dynamic, and
that requires our organizations to constantly realign their strategies
and structures to be successful.

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Obstacles to Change

• If change is so important, what makes achieving it within an
organization so difficult? In the words of Dr. John Kotter of the
Harvard Business School: “Evidence is overwhelming that the
central challenge of change is not strategy or systems or culture. The
fundamental problem is changing the behavior of people.” In other
words, individual behavior changes are essential for organizational
behavior changes. Yet people in organizations often resist change.
That resistance has many causes and can take many forms.

• Change can bring with it great economic insecurity, causing people
to worry about losing their jobs and livelihoods. We often don’t
want to change because we’re afraid of what it might mean for us
financially. Other fears emerge, as well: fear of the unknown; fear
of failure; fear of becoming obsolete; and fear of losing power,
control, and workplace friendships.

• To make matters worse, people within an organization are not
always told why changes are necessary or given an opportunity to
ask questions about how the change process will work. They may
not have much confidence or trust in their leaders to begin with, as a
result of failed change initiatives in the past. Lacking good reasons
and uncertain of the outcome, they’re naturally less than eager to
disrupt their lives.

o Illustrating this point, a mid-sized service organization recently
implemented a new compensation system that was received
with great resistance and angst by the employees.

o The goal of the new compensation system was to increase
wages to make the company more attractive in the recruiting
process and more capable of retaining employees.

o The company wanted to put more money in its employees’
pockets, yet it failed to put a credible leader in charge and take
the time to fully explain the reasoning behind the change.

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Lecture 47: Leading Real Organizational Change

o In addition, no one explained to the employees how the new
system would operate or answered their questions prior to
the rollout.

o In this situation, people
resisted the opportunity to
make more money because
of past practices and how the
change was presented to the
workforce.

• Mid- and low-level employees
aren’t the only source of
resistance to change, however.

The leadership of an organization
can be just as reluctant to adapt.

In 1963, Harvard historian Dr.

Alfred DuPont Chandler wrote an
outstanding book entitled Strategy
and Structure. Chandler found that organizational leaders tended to
allow the status quo to rule until they were forced to change out of
necessity. Businesses took action only when they were confronted
with the harsh reality that their current strategies for doing business
were no longer working in the changing marketplace.

Driving Meaningful Change

• Meaningful change in any organization—whether it is strategic,
tactical, or operational change—requires effective leadership.
When change is needed, many organizational leaders reach for a
formal organizational improvement process. These are popular
in the business world today and include such strategies as Lean
Thinking, Six Sigma, Ford’s quality operating system, kaizen , and
total quality management.

• Other leaders use less formal methods, some of which can
be aggressive, even confrontational. They send out forceful,
demanding e-mails; give passionate, burning platform pep talks;

Employees confused by a
change may become resistant
to it.

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engage in screaming, fist pounding, and fear mongering; or simply
issue mandates from on high. All these methods are capable
of creating a flurry of activity, but unless they’re applied in an
effective and perceptive way, they are unlikely to produce desired
and sustainable change.

• In fact, it has been estimated that only around 20% of all
organizational change initiatives achieve their desired outcomes,
which is a sobering thought. That means that 80% of the time,
instead of changing, leaders who are trying to achieve change are
actually wasting time, frustrating people, losing credibility, and
burning precious organizational resources.

• Inspired by his reporting on health care, writer Alan Deutschman
chronicled research findings and observations on change in a
book entitled Change or Die. He found that facts, fear, and force
alone don’t drive real and sustainable change in people’s lives.
Deutschman introduced three dynamics that must be in place for
real change to take place: relationships, repetition, and reframing.

o According to Deutschman, if we are to change, we must have a
strong relationship with someone that can give us hope that the
change we need to make is possible.

o We also need repetition. With direction from the person who is
guiding us through the change, we need to learn, practice, and
master the activities and actions that will allow the changes we
are trying to make.

o By reframing, Deutschman means that the person helping us
though the change must help us form new ways of thinking
about and understanding our situation. Reframing is needed
to help people move from thinking and saying, “I hate this
change” to “This change is going to put us in a better position.”

• Deutschman’s approach takes more time, effort, and energy. But the
change it creates is real and sustainable, which should be the goal
of every organizational and individual change effort we engage in.

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Lecture 47: Leading Real Organizational Change

A Study on Change Initiatives

• In the book The Two-Minute Drill, researchers analyzed more than
1,000 successful and unsuccessful change initiatives and found
some interesting patterns. In this research study, the people who
participated were a cross-section of executives, middle managers,
and front-line leaders. The participants identified both a successful
and an unsuccessful change initiative that they had been part of
during their careers.

• The first standout finding was the fact that the leaders made
problem solving the focus of change. Organizations must do things
differently when their current activities are not working, whether
they’re experiencing a revenue shortfall, exploding costs, poor
customer service, or lack of quality. Although all these issues
require change, the real issue is solving the problem.

• The second important finding was that although leadership is
essential to achieving organizational change, not just any leadership
will do. Real and rapid change or problem solving requires
leadership that is effective, trustworthy, and hands on. The leaders
of successful change initiatives were focused, energized, skilled,
and passionate about actually making things better. Conversely,
failed change efforts were almost always poorly led, with the person
in charge often just going through the motions of the change effort.

• Successful change initiatives also always had two other important
qualities: a sense of urgency and speed. A sense of urgency conveys
to people the importance of the effort. It can easily be translated
into the need for speed, which gives the effort forward momentum.

• Another finding represented some new thinking on the subject of
achieving organizational change: Leaders of successful change
efforts take the time to know and understand what they’re up
against when embarking on any change initiative. They determine
how well their skill sets and the skill sets of their teams stack up
against the challenge.

356

• Still more vital elements of a successful change initiative are
teamwork and talent. When you think about the problem-solving
activities needed to drive change, it makes sense that you need
motivated people who are able to work together and who have the
requisite skill sets for the needs of your project. Among other things,
you probably need people with good IT skills, others who are good
analysts, and people who have good training and facilitation skills.

• The researchers also found that successful plans invariably involve
careful monitoring. Leaders of successful change observe and
measure both individual and team performance to ensure that
the right activities are taking place to move the change forward.
Knowing that they are being held accountable for their behavior
and performance encourages people to give the change initiative
their best efforts.

• Finally, the researchers found that successful leaders of
organizational change provide feedback, coaching, and rewards to
shape and reinforce the actions and behaviors that are driving the
change. Careful monitoring enables leaders to know when desired
results are being achieved and to call attention to them, which
produces justifiable pride and satisfaction in the people whose hard
work made the change possible.

Suggested Reading

Kotter, Leading Change.

Longenecker, Stansfield, and Papp, The Two-Minute Drill.

Questions to Consider

1. Think of successful change that you were part of at work. What
was it that made it so successful? What lessons can you draw from
this experience?

2 . Do you approach change with a problem-solving mindset?

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Lecture 47: Leading Real Organizational Change

3. Do you know your own strengths and weaknesses as a change agent/
leader?

4 . Is there a problem at work right now that you need to solve? What will
be your plan of attack to make real change happen sooner rather than
later?

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Lifelong Learning for Career Success

Lecture 48

T hough the most important ingredient for career success is a track
record of delivering desired results, another critical factor is your
ability to develop your skills and talents to meet the changing
demands of your job. Furthermore, to be of any real value, our knowledge
of organizational behavior needs to influence both our thought processes
and the way we behave. To that end, this lecture will discuss the barriers
that get in the way of our ability to change, learn, and develop and how to
overcome them.

The Essentiality of Learning

• In our data-driven world, information doubles every five years, and
organizations rapidly change to keep up with the hyper-dynamic
marketplace. Performance expectations keep rising, and the
average worker will change jobs between 7 and 10 times during his
or her career.

• It should therefore come as no surprise that we must all make
lifelong learning and professional development a real priority. The
onus for developing yourself falls squarely on your shoulders.

• Although your boss and organization can help guide you and
provide important input and resources, professional development
comes down to your willingness to take control of this important
part of your work life. Remember that delivering better results for
your organization requires improving your talent.

• Successful people across virtually every discipline tend to be
lifelong learners who place a real priority on their intellectual and
professional development.

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Lecture 48: Lifelong Learning for Career Success

• Those involved in human resources and training frequently ask: Why
don’t people take their professional development more seriously?
Some answers derived from surveys include the following:

o Extreme time pressures, bad bosses, and the fact that many
people receive little or no performance feedback

o Organizational cultures that do not promote or encourage
employee development

o Organizations that demonstrate a willingness to accept poor
performance and the status quo

o Companies that fail to invest resources and create processes to
promote learning

o People who don’t take the time for self-reflection and
self-appraisal

o Out-of-control egos that prevent people from realizing that
they are in need of some work,

Breaking through with Learning

• We all face barriers that can get in the way of acquiring new skills
to meet the demands of our jobs, refining our existing talents, or
developing greater expertise in an arena that can help advance our
careers. One way to counter this is to make a habit of engaging in
ongoing learning through a five-part process.

• First, it’s imperative that we take time every day to reflect on what
we’re doing and how well we’re doing it. This means that we
become more self-monitoring and aware of our behavior, which
is a cornerstone of being an emotionally intelligent person, in this
regard, it’s important to conduct a daily S.T.O.P. in order to spend
sufficient time planning and developing a performance script for
each day.

360

• Second, it’s also imperative that we seek out and receive ongoing
feedback from people who are in a position to help us improve
our skills. Research tells us that many professionals do not get
sufficient feedback and coaching on their performance; thus, we
need to become more proactive in this regard. If your organization
does not provide you with satisfactory feedback, you need to create
your own feedback mechanisms. Take the time to build 360-degree
working relationships to increase your opportunities to get accurate
and candid feedback.

• Third, we need to learn from our mistakes and not allow them to
become habits or lifestyles. In the words of great American film
actor John Wayne: “Life is tough, blit it’s tougher if you’re stupid!”
A person who is ignorant doesn’t know what to do, but a person is
being stupid when he or she knows what to do and, for whatever
reason, doesn’t do it. When we find ourselves making the same
mistake time and time again, we damage our own performance and
run the risk that the mistake can become a deep-rooted habit.

• Fourth, ongoing learning can take place when we make seeking
out new and better ways of doing things part of our daily approach
to work.

o There is much to learn by asking good questions and by
sharpening our listening skills.

o Working closely with talented people and learning how to
emulate their thinking and behavior can help you absorb good
skills and habits.

o Newspapers and periodicals can provide us with information
about current industry trends and best practices that are
relevant to our jobs.

o When we have great working relationships, we can draw
on them when we have a question, need input in solving a
problem, or simply need a sounding board on an important
decision we’re about to make.

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Lecture 48: Lifelong Learning for Career Success

• Finally, leaders and professionals who are serious about ongoing
learning will create accountability systems that motivate and
encourage them to engage in many of the practices we’ve
discussed in these lectures. They will have regular contact with
an accountability partner, or they may even go so far as to set up
their own personal board of directors. Such systems are useful for
discussing what we need to keep doing, stop doing, and start doing
to improve our performance.

Breaking through with Professional Practices

• The second major step to keep yourself growing in your career is to
adopt smart professional development practices that will improve
your talent. Although your ongoing learning practices can go a long
way to improving your performance, from time to time, we all need
to conduct a strategic S.T.O.P. to assess whether our talent base
is where it needs to be. If it is not, we need to figure out how to
address the issue.

• First, it’s important to conduct a needs assessment of yourself
to determine your level of proficiency in the skills that are most
important for success in your current position. There’s a good
chance that when you had your most recent fonnal performance
appraisal, your boss identified an area or two that could use some
work. Once a deficiency has been identified, set a specific learning
objective for that particular skill. The more specific, the better.

• As soon as you’ve set a learning objective, it’s time to create an
improvement plan to help you develop the skills you need to be
more successful. High-performance professionals craft development
plans that are specific to the skills they are trying to perfect.

• In developing your plan, you might want to seek out formal training
and education programs around the particular skill that needs work.
Start by familiarizing yourself with the organizational training and
development programs that your company offers. You might also
be able to find a seminar or workshop offered by a local consulting
group, university, or community college.

362

• After completing a formal education program, make sure you take
steps to increase your ability to retain and apply the information
you learned. Include some specific actions from the training that
you can make part of your S.T.O.P. process.

• Within your organization, such activities as cross-training, taking
on assignments to serve on improvement teams, and participating
in on-the-job training programs might provide excellent learning
opportunities, in addition, organization-sponsored community
service, outreach programs, and volunteer efforts in the community
can be amazing skill-development opportunities.

• Just as in the case of your ongoing learning, once you have taken
the time to create a professional development plan, it is important
that you create accountability around it. Here is where having a
great working relationship with your boss, having an accountability
partner, or having a personal board of directors can come in handy
yet again. For your development plan to work, there must be specific

Volunteering is an often-overlooked way to develop your skills and talents.

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Lecture 48: Lifelong Learning for Career Success

action, ongoing feedback and reinforcement, and accountability for
action. Otherwise, the hustle and bustle of daily work will squeeze
out these important learning opportunities.

Mentoring

• Never underestimate the power of having a mentor and being
a mentor. Successful people almost always have a network of
mentors to help them make good decisions, plan more effectively,
and create and maintain professional networks. Successful people
know that mentoring other people helps them keep their feet firmly
on the ground, causes them to stay humble, and helps them stay
connected to the things going on around them.

• As we move through life pursuing our careers, it is critically
important to remember that relationships are the cornerstone of
our careers and the foundation of life. Each one of us needs to take
responsibility for being an effective mentor to the people around
us, people who are less fortunate than us, and people who have
something to gain by having access to our experience, counsel,
support, and network. At the same time, each of us needs to have a
mentor in our lives for the same reasons.

• Whether it’s improving your leadership skills, developing
your emotional intelligence, boosting your coaching or team¬
building abilities, or developing any of the other skills that we
have discussed, make use of that special mentoring relationship
to develop the knowledge and talents that are most critical to
your success.

Suggested Reading

Blauner, Coach.

Gordon, Training Camp.

364

Questions to Consider

1. What specific practices does your organization have in place to help
facilitate employee development?

2. Do you have a plan for your development around specific needs, and are
you taking advantage of the development tools that your organization
provides?

3. Do you take time on a daily basis to reflect and learn from the
experiences of each day?

4. Do you have a mentor, and are you mentoring others in your organization
to help them be successful?

365

Critical Business Skills:
Marketing

Ryan Hamilton, Ph.D.

Critical Business Skills: Marketing

Scope:

T o the casual observer, marketing can resemble a series of random
and disconnected actions. Why did a firm choose to sell through
a particular channel? Sponsor a particular event? Cast that actor
in its commercials? Locate its stores at a particular location? Price at a
particular level? Bundle its offerings with other products or services? If it
is bewildering to watch how established companies with long histories of
success make such decisions, what chance does the small business owner
have of developing and following through on a coherent marketing plan?

When viewed through the proper lens, however, this cacophony of seemingly
disconnected decisions comes into focus. As it turns out, there is a proper
sequence in which marketing decisions should be made—an order that can
be imposed on all the choices marketing managers must make.

All marketing decisions can be divided into two groups: those that affect
the firm’s marketing strategy and those that concern the tactics it will use to
implement this strategy. These two types of decisions are not equal: Strategy
takes precedence over tactics and, thus, must always be decided first.

This section of the course is structured around this distinction. In the
first lectures, we will discuss how to develop a marketing strategy by
thoughtfully answering three basic questions: Who are your customers?
What do they value? How can you give them what they value better than
the competition? If you understand the answers to those three questions, you
have a marketing strategy.

We will cover a number of topics on our way to answering the three all-
important questions: segmentation, targeting, positioning, sources of value for
the customer, how to grow a market, and sources of value for the company.
After we have discussed marketing strategy, we will dive into marketing
tactics. These topics include products and services, branding, pricing, and
communications, including advertising, social media, and word of mouth.

369

Scope

At the conclusion of these lectures, we will discuss the basics of market
research. In particular, you will learn the many different types of methods and
data you have at your disposal for getting insights into who your customers
are, what they value, and how they make decisions. Throughout the lectures,
these principles are illustrated with examples from industry and from
academic research in marketing, psychology, and behavioral economics.

Marketing done well is the basis on which companies grow, innovate, and
fend off competition. Marketing done poorly, however, is hard to distinguish
from throwing money out a window. This section of the course is designed
to provide you with the tools you need to understand marketing and make
sound marketing decisions. ■

370

What Is Marketing?

Lecture 49

T he term marketing is often defined too narrowly. Many people, for
example, treat marketing as if it were just advertising—something
that’s done after all the other important decisions about a product
have been made. Others see marketing as synonymous with sales. Again,
according to this view, all the important decisions are made first; then,
marketing is brought in to push the offerings onto customers. But marketing
is much broader than either advertising or sales. Marketing is the process of
facilitating exchanges that create value for customers, collaborators, and the
company. And marketing creates this value by developing an understanding
of what customers want and need. In this lecture, we’ll explore the types of
value that customers seek.

Defining Marketing

• The definition of marketing as the function of a business that creates
value for customers and the company is not universally accepted.
Many people—even business experts—believe that value is created
by innovations; in other words, value in a product is produced by
scientists and engineers working in a lab.

• This disagreement is rooted in a difference of opinion over what
constitutes value from a business perspective. Some people view
value as something intrinsic to the offering. In this view, if a
company adds features to an offering—gives it a faster processor
or makes it more fuel efficient—then the value of that offering is
increased. However, adding a new feature increases the value of a
product only if customers decide that they value the improvement.

• In other words, an offering’s value should be determined only from
the perspective of the customers who are willing to buy it.
o If we use this customer-centric definition of value, then
we understand that innovations developed in a lab are not
intrinsically valuable. An innovation must be matched with a

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Lecture 49: What Is Marketing?

set of customers who will appreciate it; it must be explained to
those customers in a way that they will understand; it must be
priced in such a way that customers will be willing to pay for
it; and so on. Those are all functions of marketing.

o Marketing is what turns something with the potential for
creating value into something that actually creates value for the
customer and the company.

• It’s true that occasionally, an innovation comes along that essentially
sells itself; it’s so great that people flock to it. But it is also
distressingly common for
groundbreaking innovations
to fail the first time in the
market, only to be replaced
later by a better-marketed
imitation. The success of the
PalmPilot over earlier digital
assistants created by Apple
and Motorola serves as
an example.

Types of Value

• It’s a mistake to assume
that if you like a product,
your customers will, too.

The fact is that people are
different, and the people

who make marketing decisions about products and services are
likely to be different from their customers. If you’re going to be
successful in marketing, you need to respect and try to understand
those differences.

The manufacturer of the PalmPilot
was extraordinarily successful
with a device that was actually less
complex than other personal digital
assistants on the market at the time.

• Instead of basing marketing decisions on your own preferences, it’s
important to recognize that there are different types of value that
customers may get from an offering. In particular, we can identify
four types of value: functional, monetary, social, and psychological.

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o Functional value is the degree to which an offering fulfills
its purpose or solves a customer’s problem. For example,
the functional value of bottled water is that it quenches thirst
and hydrates. Products and services differ in terms of their
functional value to the extent that they are better at fulfilling
their functional purpose.

o Monetary value is a function of the price paid for an offering
relative to its perceived overall worth to the customer. As
such, monetary value is not completely distinct from the other
sources of value but, rather, invites a trade-off between those
other types of value and monetary costs. Monetary value can
provide a compelling reason for choice.

o Social value is the extent to which owning a particular product
allows consumers to connect with others.

o Psychological value is the extent to which owning a product
allows customers to express themselves or make themselves
feel better. Sometimes, all customers are looking for from
an exchange is to feel appreciated, respected, comforted,
or hopeful.

• The key insight here is not just that people derive value from these
four sources but that these sources of value are not all equally
important. In fact, the importance of each source of value depends
on the customer. For some people, one of these sources of value,
such as monetary or functional, is nearly always paramount.

Understanding Customers

• One way for marketers to use these four sources of value is to
consider whether their target customers are, on average, more
motivated by functional, monetary, social, or psychological value
when they shop. Some people have a primary motivation, and your
target customers may be among them.

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Lecture 49: What Is Marketing?

• It is much more common, however, for any particular customer
to give these different sources of value greater or lesser weight
depending on the purchase. When shopping for a washing machine,
for example, you might seek functional value; you want a machine
that is energy efficient and reliable. When buying office supplies,
you might be primarily driven by monetary value. You may not
necessarily buy the lowest-priced offering, but you want to make
sure you get a good price.

• The key for marketers is to determine which source of value
their customers are seeking in a particular transaction. If you
are mistaken in this determination, you may be wasting your
marketing efforts.

• You shouldn’t necessarily assume that your customers are primarily
motivated by monetary or even functional value. In many cases,
these sources of value may be the most important factors customers
consider, but not in all cases.

o In recent years, some large hospital systems have moved away
from a policy of never admitting mistakes to patients for fear
of lawsuits to a policy of being open and honest with patients
when mistakes are made.

o This shift recognizes that some malpractice suits might be
motivated by a desire for psychological value rather than
monetary concerns. Under a full-disclosure policy, hospitals
provide this value to patients by admitting mistakes, sincerely
apologizing, and keeping patients fully informed. The result is
that malpractice suits have dropped dramatically.

o For example, in 2001, there were 262 lawsuits against the
University of Michigan Health System before it adopted
a policy change. By 2007, after the change, the number of
lawsuits dropped to 83.

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• Understanding your customers’ primary source of value also allows
you to position your offering in a way that provides them with a
reason for choosing your product. Some product attributes are
naturally consonant with certain sources of value.

o For example, if your offering is the low-priced leader in the
market, then it is especially likely to appeal to customers who
seek monetary value.

o But many product attributes can be communicated in ways that
emphasize each of the sources of value. For example, a truck
with a powerful engine can be positioned to appeal to those
seeking functional, psychological, or social value.

• For a given product attribute, there is often a positioning decision to
be made: How do you communicate the advantages of that attribute
to the customer? To answer that question, you should know the source
of value that is most likely to drive choice for your target customer.
If it’s social value, then communications emphasizing psychological
benefits may fall flat. The key is to translate the value offered into the
reasons the customer is likely to generate for his or her choice.

Key Marketing Questions

• We now have a clear definition of our topic: Marketing is the
business function that creates value for customers and the company.
With that definition in mind, we can begin to address some crucial
marketing problems: How do you create a brand? How should
you price a product or service? Where should you sell it—and to
whom? What type of advertising should you use? What benefits
should you communicate? This list of questions can quickly
become overwhelming.

• But as we’ll see over the course of the next several lectures, not all
marketing problems are equal. Some are more important than others
and must be solved first. To begin, then, let’s identify the three key
questions that you must answer before you address any others.

o Who are your customers?

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Lecture 49: What Is Marketing?

What do they value?

o How can you give them what they value better than
the competition?

• If you can answer those three questions, then you have the basis
for a marketing strategy. And you must have a defined marketing
strategy before you try to figure out the best tactics to use to
accomplish it. In our first six lectures, we’ll learn how to develop a
marketing strategy by answering these three fundamental questions.
In the second six, we’ll investigate marketing tactics, addressing
such issues as branding, pricing, and communication.

Suggested Reading

Chernev, Strategic Marketing Management, chapters 1-2.

Questions to Consider

1. Pick a product or service with which you are familiar and conduct a
reason-based choice analysis of that offering. Consider the four potential
sources of value a customer could get from that offering: functional,
monetary, social, and psychological. What reasons might consumers
have for choosing this offering over its competition in each of those four
domains? How might that offering be improved by increasing one type
of value?

2. Pick an attribute on which a product or service could differentiate itself
(e.g., the most powerful engine in its class). Translate the benefits of
that attribute into a reason in each of the four value domains: functional,
monetary, social, and psychological.

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How to Segment a Market

Lecture 50

W e’ve already seen that the first question in developing a marketing
strategy is: Who is the customer? Segmentation is how you
begin to answer that question. In fact, segmentation is how you
answer an even more basic question: Who are the possible customers you
could serve? Segmentation is simply the process of grouping people together
according to what makes them similar. To make this process as effective as
possible, you should start with the universe of all potential customers for
your product or service. In this lecture, we’ll look at three approaches to
segmentation analysis, each of which results in a list of customer segments
with a rich description of their preference structures.

Principles of Segmentation Analysis

• The first principle of segmentation analysis is that there is no single
“right” way to segment a market. Different brands can successfully
segment exactly the same market in radically different ways.

• It’s also important to understand that segmentation is not a one¬
time prospect. Markets are fluid. New customers come in, existing
customers move out, competitors come and go and gain and lose
market share. It is not enough to segment a market once and never
return to it again. You should re-segment the market periodically;
doing so is a great way to identify new opportunities or fix
existing problems.

• When you conduct segmentation analysis, the segments should
be both collectively exhaustive and mutually exclusive. In other
words, everyone in the market should be in a segment, and each
segment should be distinct and, to the extent possible, not overlap
with any others.

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Lecture 50: How to Segment a Market

• Perhaps the most important principle of segmentation is this: The
segments you form should be based on what people value, not on
differences in demographic characteristics, such as age, gender,
geography, and so on. You will eventually create demographic
profiles of your segments, but it is usually not helpful to start
with demographics.

o The idea of segmenting by value rather than demographics is
counterintuitive. When you ask someone to divide potential
customers into groups, it is only natural to start by putting men
and women into different groups or putting people of different
ages or incomes into different groups.

o Further, marketers often provide descriptions of their target
customers based on demographics. Such a description might
read: “young men, ages 16 to 22, from upper-middle-class
households, living in suburban neighborhoods, with moderate
levels of disposable income.”

o That sounds like a specific target, but think of the diversity of
identities, motivations, desires, and values contained within
just that one fairly specific demographic segment. Those
young men could be cool kids or outsiders, conformists or
nonconformists, and so on. They certainly don’t all want the
same things, buy the same brands, or try to project the same
image to the world.

o Segmenting people by demographic descriptors alone will not
tell you anything about the underlying values that drive their
decision making. If you create segments based on surface
differences only, you won’t know what to do with the segments
when you’re done.

• The alternative to demographic profiling is to divide your market
into psychographic segments, grouping people based on similarities
in their psychological needs and desires.

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Case Study in Psychographic Segmentation

• A major cable television provider found that its customers were
unsubscribing and either switching to another provider or cutting off
their cable service completely. To address this problem, the company
decided to do a segmentation analysis to identify those customers
who were most likely to defect and take steps to limit defections.

• The company used its extensive customer database to create several
distinct customer groups and identified one group that was both
particularly profitable and particularly likely to leave. The task,
then, was to establish a plan to reduce defection rates in this group.
Options included lowering prices for this group of customers,
offering a discount on specific services, upgrading services in
particular areas, and so on.

• But because this customer segment was created by looking at
demographic similarities rather than value-based similarities, the
company had no way of knowing which plan would work to retain
customers. It knew that this group was in danger of defecting, but
the segmentation didn’t explain why the customers were leaving.

• Instead of segmenting by outward similarities, suppose the
company had investigated the reasons people have for subscribing
to cable in the first place. This approach might have identified
different customer groups, such as Price Sensitives, Sports Junkies,
Technology Lovers, and so on.

• This kind of segmentation is more difficult than demographic
segmentation, often because it requires additional market research.
But such a value-based psychographic segmentation is infinitely
more useful than a demographic one.

o For example, what if, after conducting psychographic
segmentation, the company discovered that Technology Lovers
were both especially profitable and especially likely to cancel
their service?

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Lecture 50: How to Segment a Market

In that case, the company would have a clear path forward to
retain these customers: Invest in new technology, introduce
technological innovations, and trumpet technology in
its advertising.

o Offering lower prices to this group probably wouldn’t halt
defections because these customers weren’t leaving to seek a
better price. It’s even possible that lower prices could make
these customers think that the company is a bargain-basement
provider and cause them to leave even faster.

Approaches to Segmentation

• There are three approaches to conducting a segmentation analysis:
user based, benefits based, and occasion based. Each of these
approaches should lead to the same outcome: a mutually exclusive
and collectively exhaustive set of customer segments, grouped
based on similarities in their underlying values.

• A user-based analysis involves creating a list of the different types
or classes of people who might use your product or service. For
example, we could identify a number of groups of people who
might use satellite phones: military personnel, international
journalists, nongovernmental organizations (NGOs), international
business travelers, and first responders.

o The next step is to determine important features for each of
these groups when they are considering a satellite phone
purchase. Military personnel, for example, might value
ruggedness and ease of repair in the field. International business
travelers might be more focused on small size and ease of use.

o The end result of this exercise should be a list of customer
segments with a rich description of the preference structures
for each group. The more detailed and specific you can get in
describing what each group would want from the product or
service, the better off you will be when it comes time to pick a
target and position your offering.

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o Once you have created a detailed list of segments, the next step
is to see if any of the groups overlap in terms of what they
value. If two groups want almost exactly the same features
in an offering, you should probably combine them in one
segment. You might also find that the initial user groups you
defined should be broken into subsegments. For example, after
further research, you might learn that different types of NGOs
value different features in satellite phones.

• With the second approach to segmentation, benefits-based analysis,
you start with the offering itself rather than the customers. Think of
the different types of benefits a customer might derive from using
your product or service, then determine the segments accordingly.
Ask yourself: What benefits are most likely to drive a purchase in
this category?

o For example, consider the benefits of breakfast cereal: It’s
sweet, makes an inexpensive meal, is fast and easy to prepare,
is heart healthy, and makes a great snack.

o The next step is to determine which groups of people would
appreciate each particular benefit. Families with school-aged
children, for example, might appreciate the fact that cold cereal
is fast and easy to prepare.

o As with user-based segmentation, the end result of a benefits-
based segmentation should be a list of customer segments with
a rich description of preference structures.

• The third approach, occasion-based segmentation, differs from
the other two in that it doesn’t start with the premise that each
person or household should be assigned to a different segment.
Instead, it recognizes that the same person may have different
needs depending on the occasion for using the offering. Thus, this
approach starts by asking the question: When would consumers buy
or use this product or service?

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Lecture 50: How to Segment a Market

For example, someone might buy wine to accompany a meal,
to have on hand for a party, to give as a gift, for personal
consumption in the evening, or to use in a religious ceremony.
Unlike a user-based segmentation, any particular customer
might fit into any or all of these occasion-based segments.

o After you have a list of occasions, the next step is to generate
a list of the things people would value in the offering in each
of those situations. For example, what features would someone
look for in buying wine to accompany a meal versus to give as
a gift?

• The difference among these three segmentation approaches—user
based, benefits based, and occasion based—is in providing you
with different places to start the process—different angles for
looking at the same market. But all the approaches should lead
to the same result: a list of customer segments that differ in their
preference structures.

• Value-based segments are useful because they tell you what types
of marketing actions will appeal to certain groups of people, but
they don’t help you identify and communicate with those people

Knowing what their target segments value enables retailers to customize their
stores to better serve these segments.

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specifically. Thinking back to our cable company example, you
wouldn’t be able to distinguish a Technology Lover from a Sports
Junkie in a crowd.

o For this reason, it is usually necessary to layer a demographic
description on top of your value-based segments.

o Keep in mind, though, that it’s still important to conduct
psychographic segmentation first. It is much more useful to
determine that a segment of customers values your product
because it meets some specific set of needs than it is to
determine the ages or addresses of your customers.

Suggested Reading

Chernev, Strategic Marketing Management, chapter 3.
Yankelovich and Meer, “Rediscovering Market Segmentation.”

Questions to Consider

1. Choose a market for a particular product or service (such as flowers,
rental cars, paper towels, or tax preparation) and try segmenting the
market three times, using each of the three methods discussed in the
lecture. Did each of the methods result in different segments, or were
the segments largely the same? (Either is possible, depending on the
market you select.) If your segmentation strategies resulted in different
segments, is there a way to combine insights from these segmentation
processes into a new segmentation of the market?

2. Choose a segment you identified in the previous exercise or one your
employer currently serves. Develop an archetype of that segment—a
rich description of a fictional character that embodies the segment’s
important psychographic and demographic characteristics. Create a
mini-marketing plan for the segment. Where would you advertise
to reach your archetype? Which sales pitches are likely to be most
effective? Which competitors’ products are members of this segment
most likely to buy?

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Lecture 51: Targeting a Market Segment

Targeting a Market Segment

Lecture 51

I n the last lecture, we saw how to group potential customers into segments
based on similarities in what they value. In this lecture, we’ll discuss
targeting, that is, deciding which of those segments you will serve and
which ones you will not. Some companies use segmentation to identify all
the groups of people they will sell to, then pursue all those groups with the
same offering. But that approach is a little like separating your laundry, then
throwing all your clothes in the washer at once. As we’ll see in this lecture,
to get the most out of segmentation, you must decide which groups are a
good match for your offerings; otherwise, your marketing will fail.

Selecting a Single Target

• Targeting is the process of deciding which customer segments you
will serve and which ones you will not. The key here is to recognize
that by creating value for one segment, you will almost certainly
make your offering less attractive to other segments. It’s important
to know who your customer is and—just as important—to know
who your customer is not.

• For many businesspeople, it’s difficult to face the fact that some
potential customers exist who will not spend money to buy their
products and services. That knowledge is painful; thus, these
businesspeople are tempted to go after everyone, but that’s a mistake.

• Unless you run a monopoly, such as a power company, your
customer can’t be everyone. You must pick a target and try to meet
the specific needs of that segment. If you try to create something
that will appeal to everyone, you will probably end up creating
something that appeals to no one.

o Suppose you’ve done a value-based segmentation analysis, and
you’ve discovered that there are only two types of customers
in a certain market: those that prefer blue and those that prefer
red. As a manufacturer, you can choose to paint your offering

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blue to target the blue customer group, or you can paint it red
and appeal to the red customer group. But what if you paint
your product purple and ask both groups to meet you halfway?

o If you are a monopolist, that approach may work. Neither
segment gets what it wants, but the customers have nowhere
else to go. Both groups buy the purple option rather than go
without, and you get all the customers.

o However, if other manufacturers come along that are willing
to provide offerings that are just red or just blue, your
compromise solution will become a second-best option for
all customers in the market. Without a specific target in mind,
your competition will outflank you by providing each customer
segment with something much closer to what it wants, and you
will lose everyone.

• Of course, in the real world, customer segments aren’t as easy
to identify as blue lovers and red lovers, but the basic principle
remains the same: You must have one target. Targeting is at least
as much about defining who your customer is not as it is about
deciding who your customer is.

• Even with products that are bought by one person but consumed by
others, such as products for children, it’s still important to identify
one target. Consider, for example, brands of yogurt that seem to
target both parents and children.

o Horizon Organic brand yogurt seems to target children with a
logo of a cartoon cow riding on a snowboard. But the copy on the
packaging for this yogurt emphasizes the fact that it is organic
and low fat and that no antibiotics, pesticides, or hormones
were used in its manufacture. This is a yogurt that a particular
segment of parents would love for their children to eat.

o But if this offering is targeted to parents, why does the company
use a cartoon cow for its logo? The answer is that part of the
value that parents get from this yogurt is that their children will

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Lecture 51: Targeting a Market Segment

eat it. In other words, targeting one group of customers—in
this case, parents—does not mean ignoring the preferences of
other groups involved in the acquisition and consumption of
the offering.

o Other yogurts for children also use cartoon characters on
their packaging, but these characters are often from popular
television shows. Such offerings are clearly targeted to those
who tend to have strong attachments to cartoon characters—
that is, children. However, many of these brands also emphasize
that the yogurt is low fat or a good source of calcium to show
that they aren’t simply ignoring the concerns of parents.

o Why don’t we find an offering designed to appeal to both
children and parents? Because it is usually one group or
the other that drives the decision making in this category. A
middle-of-the-road option would be outflanked by the yogurts
targeted to children when children choose and by Horizon
Organic when parents choose. By trying to target both groups,
a manufacturer would probably miss both.

Making an Offering with Value

• One common mistake firms make is to target a segment just because
that segment is attractive to the company. Perhaps members of a
certain segment have a great deal of disposable income, or perhaps
they’re opinion leaders and could improve the brand’s image if they
start using the product. But the value that the customer provides to
the company is only half of the equation. You also must consider
whether the company is capable of creating an offering that the
target customer actually wants.

• For example, in the early 1980s, the western-wear company Levi’s
conducted extensive research to re-segment its market and look for
opportunities for growth. The results of the research showed that one
small segment of the market accounted for a vastly disproportionate

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share of spending on men’s clothing. These “Classic Independents”
loved to buy high-end clothes, particularly three-piece suits, and
had somewhat conservative tastes.

o Levi’s reasoned that capturing just a portion of the money this
segment spent on clothes would drive real revenue growth
for the company. Thus, the firm developed a line of high-end
suits in conservative cuts and colors. The quality of the suits
was fine, but none of the accompanying marketing choices
made by Levi’s created any additional value for the Classic
Independent segment.

o The company sold the suits through retailers with which it
already had a relationship, such as Sears, but of course, the
Classic Independent segment would never go to Sears to buy
a suit. Further, the suits were too expensive for the stores
where they were sold but too inexpensive compared to what
the Classic Independents usually paid for suits. Even the Levi’s
classic brand was a liability because it was not associated with
high-end menswear.

• It is certainly necessary for a segment to be attractive to your
company, but it’s not sufficient. Customers in that segment must
also find your offering attractive. In other words, you must be in
a position to sell an offering that will create value for the segment
you target. Both parties must come away from the transaction better
off, or the transaction won’t take place.

The Attribute-by-Segment Matrix

• A valuable tool to use in choosing a target is the attribute-by-segment
matrix. To create this matrix, you must know three factors: the
possible segments you could target, the attributes that are important
in your product category, and the performance of your offering and
the offerings of your competitors on those attributes. We’ll construct
a matrix using three offerings in the video game system market:
Sony PlayStation (PS3), Microsoft Xbox, and Nintendo Wii.

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Lecture 51: Targeting a Market Segment

Customer Segments

Non-

Attributes Gamers Gamers

Cutting-edge graphics H L

Highly involved games H L

Complex storylines H L

High skill levels H L

Realistic graphics H L

Ease of interface L H

Competitors/Company

Xbox PS3 Wii

H H L

L L H

An attribute-by-segment matrix is a valuable tool for identifying targets that may
be underserved by current offerings.

• To construct the matrix, first list the attributes that might be
important for your product, framing each attribute in a positive way.
For example, for a video gaming system, attributes might include
cutting-edge graphics, highly involved games, complex storylines,
realistic graphics, high skill levels, and ease of interface.

• The next step is to make columns for each of the customer segments.
For our purposes, we’ll consider only two broad segments: gamers
(those who have played video games for years) and non-gamers
(those who have much less experience with video games).

• We then determine how each of these segments would rate the
importance of the attributes listed. For example, gamers would likely
rate all of the attributes except ease of interface as highly important,
while non-gamers would probably find cutting-edge graphics and
complex storylines less important than ease of interface.

o Note that in this listing, the gamers and non-gamers have
completely different preference profiles: What’s important
to gamers tends to be less important to non-gamers and vice
versa. But that may not always be the case.

o Depending on how you construct your matrix, there may be
certain attributes that are important to all segments and others
that are important to none. But at the end of the process, you

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should not have two or more segments that value exactly
the same things across the board. If that’s the case, then the
two segments are probably the same and should be collapsed
into one.

• Once you’ve mapped the attributes to customer values, the next
step is to look at the performance of your company and that of your
competitors. In our example, the Xbox and PlayStation systems
perform high on all the attributes except ease of interface,
o In the early 2000s, Nintendo looked at this competitive space
and realized that it would be difficult to compete against
PlayStation and Xbox if it went after the gamer segment.
Gamers already had two strong options to choose from that
seemed to match their preferences exactly. Thus, instead of
directly competing against Microsoft and Sony, Nintendo
chose to create an offering targeted to non-gamers: the Wii.

o Asa gaming system, the Wii was well behind other consoles
on the attributes that mattered most to gamers, such as cutting-
edge graphics and highly realistic play. But Nintendo focused
its efforts on creating a simple and intuitive way of interacting
with the game system, concentrating on the one attribute that
was most important to non-gamers: ease of interface.

o Many gamers scoffed at the Wii when it was first introduced,
but Nintendo wasn’t trying to create a game console that would
appeal to that group. Instead, Nintendo chose a target that
was not served well by Sony and Microsoft—a segment that
included young children, older adults, and casual gamers who
were mostly interested in family fun. And Nintendo customized
its offering to serve that segment.

o Nintendo succeeded by following the rules of targeting: Don’t
try to create a middle-of-the-road product designed to appeal
to everyone. Instead, identify a target precisely and create a
product that meets the specific needs of that target.

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Lecture 51: Targeting a Market Segment

Suggested Reading

Chernev, Strategic Marketing Management, chapter 3.
Yankelovich and Meer, “Rediscovering Market Segmentation.”

Questions to Consider

1. Choose a particular market about which you have some expertise or are
willing to do some research. First, segment that market. (You can save
some time by using the segmentation you developed in the assignments
for the last lecture.) Then, construct an attribute-by-segment matrix.
Start by generating a list of the attributes that might be important to
different consumers and on which competitors might differentiate
themselves. Next, rate the likely importance of each attribute to each
customer segment. Finally, rate the offerings of the major competitors
in the market based on how well they perform, in relative terms, on
each of the attributes. Now, match the offerings to the segments. Do the
offerings each map well onto a target segment? Are there any offerings
that don’t seem to fit with the needs of any particular segment?

2. Conduct a similar analysis of a particular market, but this time, instead
of just looking to describe the current state of that market in an attribute-
by-segment matrix, look for opportunities. If you were to introduce a
new offering in this category, which segment would you target and why?
Is there an incumbent brand that serves customers in a target segment
but does not meet all their needs? Are there any segments that look as if
they are not currently being served by any particular brands?

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Positioning Your Offering

Lecture 52

A ccording to what we might call the “better mousetrap” philosophy
of business, customers should evaluate the offerings of various
companies, then beat a path to the door of the firm that develops
the best mousetrap. Many people believe that the business world should
work in this way, with no puffery or spin from marketers. But in fact, it is
more common for great products to fail, not because of the deceptions of
marketers, but because the marketers themselves fail to communicate the
true value of their offering. In this lecture, then, we’ll look at positioning—
the process of determining which aspects of an offering are most important
in creating value for the customer, then clearly communicating that value.

The Positioning Process

• The positioning process involves two steps and two checks. First,
we start by developing an offering’s value proposition. Second, we
select the one or two key benefits that anchor the positioning. The
two checks that ensure the positioning achieves its objectives are:
(1) Does the positioning create value for the target customer, and
(2) does it differentiate the offering from the competition?

• The value proposition is an objective assessment of all the benefits
of buying, owning, and consuming a product or service, written
from the customer’s perspective.

o For example, the value proposition for Volvos in the 1980s
might have included a number of benefits: a valued image
for European imports over domestic cars, high perfonnance,
comfort, safety, reliability, and luxury.

o In a better-mousetrap world, a marketer would simply
communicate these benefits to customers and let them decide.
This approach would seem to make a lot of sense. After all.

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Lecture 52: Positioning Your Offering

telling potential customers that a car is luxurious, safe, reliable,
and exclusive should be more persuasive than telling them
about just one of those attributes.

o But Volvo didn’t take the approach of throwing the kitchen
sink at its potential customers. Instead, it successfully
implemented the second step in positioning, which was to
choose just one key benefit to communicate to customers:
safety. The main message of the cars’ safety was delivered
repeatedly in Volvo’s advertising.

o Volvo was so successful in establishing the link between its
brand and the safety attribute that this perception continues to
this day, although Volvo no longer makes the safest cars on the
road. How did Volvo create such an enduring impression in the
minds of consumers? Instead of overwhelming customers with
all the features that make a Volvo great, the company positioned
the brand on its strongest attribute and created something that
customers could understand and remember.

• In contrast, TiVo, the first company to market a digital video
recorder (DVR), should have enjoyed a first-mover advantage when
it introduced a radical technology that would fundamentally change
the way people watched TV.

o The value proposition for TiVo included such benefits as
the ability to pause live TV, to watch a show on demand, to
preschedule recording of selected shows, to skip ads, and to get
recommendations about other shows customers might enjoy.

o TiVo should have chosen the one benefit from that list
that would most likely resonate with the company’s target
customer. But instead, the company opted to highlight all the
potential benefits of the new technology, essentially delivering
the message: TiVo can do everything.

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Despite being the first to market with a product that people
loved, 14 months after launch, TiVo had only 42,000
subscribers. And before long, the competition swept in. As of
2012, TiVo had captured only about 4.5% of the DVR market.
Being the first to build a better mousetrap was not enough.

o TiVo was eventually able to explain its complex message
and educate consumers on the many virtues of the DVR.
Unfortunately, by that time, many consumers were using their
newfound knowledge on DVR systems they had purchased
from other companies.

• It’s important to remember that your value proposition is not your
positioning. Don’t tell your customer everything that is great about
your offering all at once. Keep your message simple! Very rarely
are consumers sufficiently motivated to process and understand
complex messages. And when consumers don’t appreciate how
great your offering is, simply giving them more information is not
the solution.

Creating Value for the Target Customer

• The first check on positioning is to ask: Does the positioning
clarify the value that is being provided to the target customer? One
way to think about positioning is as the flipside of targeting. After
all, you can’t hope to successfully position an offering without
knowing for whom you are trying to position it. A given benefit
will not create value for everyone. When choosing the one benefit
you want to position on, look to your target customers. What do
they value most?

• Imagine that you have been hired by a large American city to
implement a bike-sharing program. To design this program, you
need to make a number of decisions: Where will you place the
terminals where people borrow or rent bikes? How much will you
charge to rent bikes? What kind of bikes will you use? In short, how
will you position your new bike-sharing program?

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Lecture 52: Positioning Your Offering

Positioning a car around the benefit of safety works only if you are targeting
a group of customers for whom safety is the primary driver of automobile
purchase decisions, such as parents of young children.

• A good way to start would be to recognize that different groups
of people want different features in a bike-sharing program; thus,
it’s important to identify the different potential targets for your
program. A list of potential users might include commuters, people
running errands, exercisers, and tourists.

• All of these groups would value convenience, but each group
would find different locations convenient. Commuters would want
locations close to both home and work, while those running errands
would want spots near shopping hubs. Each of the groups might
also prefer different kinds of bikes.

• The point here is that without knowing who your targets are, it
is impossible to position your offering coherently. The dozens of
decisions you must make in terms of what benefits to offer could
either create or destroy value for your customer, depending on who
your customer is.

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• The mistakes of the SmartBike DC program in Washington, DC,
launched in 2008, underline the lesson that positioning can make or
break an offering.

o Bike terminals in this program were placed in inconvenient and
inappropriate locations; the bike designs were unattractive and
impractical; restrictions were placed on check-out times; and
users had to purchase an annual pass. In short, SmartBike was
systematically positioned not to create value for any particular
group of customers who might have had reason to use the
bikes. The program was terminated two years after its launch.

o Fortunately, a later program, Capital Bikeshare, corrected the
mistakes of SmartBike and has been quite successful.

Differentiating from the Competition

• The second check on the positioning process is to ensure that you
differentiate your offering from the competition. An important part
of positioning a product is giving consumers points of parity with
other offerings—that is, telling people what your product is like—
and defining points of differentiation—that is, telling people why
your offering is different from, and superior to, other offerings.

• To understand these ideas, let’s look at advertising in the category
of men’s shower gels.

o A commercial for Unilever’s Axe shower gel identifies the
product’s competition as women’s soaps. The commercial
then defines the brand’s point of differentiation relative to this
competition: a masculine scent.

o Similarly, in its commercials, Nivea for Men identifies its
competition as Axe and its point of differentiation as a more
subdued scent. The competition for Dove Men + Care is other
men’s body washes, and its difference is that it is clinically
proven to fight skin dryness. Finally, Gillette identifies its
competition as Dove Men + Care and its point of difference as
its ability to fight odor.

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Lecture 52: Positioning Your Offering

• Note here the degree of variety in terms of positioning an offering.
In just one relatively mundane category—men’s body wash—
different brands each chose unique attributes on which to position,
and each chose a slightly different competitor or set of competitors
against which to make its comparisons. Each brand defined its
competition, then communicated the one way in which it was better
than that competition.

• Note, too, that none of the men’s body washes has positioned itself
against bar soaps in general, although Axe defined its competition
as women’s soaps. It seems almost shocking that these brands all
position themselves relative to the narrow category of body wash,
when the larger soap category seems to hold so much opportunity
for growth. Thus, the second lesson we can learn from this example
is to think broadly when choosing your competition.

• One good way to articulate your positioning strategy is to craft a
positioning statement: a single sentence that encapsulates everything
that is important about the offering’s position in the marketplace.

o Positioning statements are not taglines or slogans. They are
primarily for internal consumption—for keeping the marketing
department (and, ideally, the company) focused and on message.

o Positioning statements contain several important pieces
of information: a brief description of the target customer,
identification of the product category that serves as the
competition (to establish points of parity), and a clear articulation
of the primary benefit the offering presents to the customer
relative to the competition (the point of differentiation).

Suggested Reading

Chernev, Strategic Marketing Management, chapter 4.
Gourville, “Eager Sellers and Stony Buyers.”

Questions to Consider

1. Pick a product with which you are familiar. Develop a value proposition
for that product—a list of all the benefits and costs associated with
buying and owning it. Now pick one attribute you would use to position
that product. How would your positioning change if you chose to target
a different segment?

2. Pick a product category and watch as many commercials and read as
many print advertisements as you can for competitors in that space.
Determine how each of the competing brands has positioned itself.
What are the points of parity each brand claims with its competitors?
What are its points of differentiation? Who are its target customers?

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Lecture 53: Identifying Sources of Sales Growth

Identifying Sources of Sales Growth

Lecture 53

I n 1957, a mathematician and business strategist named Igor Ansoff
published an article in the Harvard Business Review about the potential
sources of sales growth. The focus of his article was diversification, a
topic that we’ll cover in this lecture. Almost as an aside, Ansoff proposed
a framework for classifying different opportunities for sales growth. This
two-by-two matrix, discussed in just a few paragraphs in an article that was
primarily about something else, turned out to be one of the most powerful
ideas in marketing. In this lecture, we’ll look in detail at the Ansoff matrix,
as well as another marketing tool, gap analysis.

The Ansoff Matrix

• The Ansoff matrix is a simple chart, as shown below. On the left
side, customers are grouped into two categories: current customers
and new customers. Across the top of the chart are two classes of
offerings: current offerings and new offerings. The intersection of
customer types and offerings creates four boxes that categorize
opportunities for sales growth.

Current Customers
New Customers

• The first of these opportunities is market penetration, a situation
in which a business sells its current customers more of its current
offerings. Product development takes place when a business
develops new products to sell to its current customer base. Market
development encompasses sales of an existing product line to a
new group of customers, and diversification includes sales of a new
product line to a new group of customers.

• The Ansoff matrix lays out four sources of new sales and is a
powerful tool for identifying new ways to grow your business.

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Current Offerings New Offerings

Market Penetration

Product Development

Market Development

Diversification

Market Penetration

• Market penetration usually
involves selling more of
your current product line to
your current customers. This
strategy is typically the least
risky means of increasing
sales and, surprisingly, the
avenue for growth that is
most often overlooked by
marketers seeking to increase
sales. Selling a little more
to people who have already
indicated that they like your
offering should usually be the
approach you try first when
looking for opportunities to
increase sales.

• One strategy for enticing
your current customers to
buy more of the offerings they already buy is to create additional
occasions for them to use the product or service. Levi’s Dockers
brand used this strategy effectively in the early 1990s.

o Dockers recognized the trend toward less casual business attire
for men—especially the idea of “causal Fridays” at the office—
as an opportunity for increasing sales. The company promoted
and even shaped this trend through a pamphlet entitled “Guide
to Casual Businesswear” that was mailed out to 25,000 human
resource directors.

o Most people who would wear Dockers to work once a week
probably already owned Dockers for some other use, such as
weekend outings with friends. By promoting casual Fridays,
Dockers was not introducing its product to an entirely new
group of customers. Instead, it provided current customers with
a new opportunity to buy more of the current product line.

With casual Fridays, Levi’s identified
and exploited a cultural opportunity
to sell more of its current product—
Dockers—to current customers.

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Lecture 53: Identifying Sources of Sales Growth

• Another example of a well-executed market penetration strategy
comes from Ann & Hammer baking soda.

o Baking soda is a commodity product, and historically, it was
used almost exclusively for baking alone. If Arm & Hammer
wanted to sell more of its product to its current customers, it
faced the difficult task of trying to encourage more baking.

o Instead, the marketers at Arm & Hammer leveraged the ability
of baking soda to clean and deodorize and identified dozens
of non-baking uses for the product, such as freshening the
refrigerator, whitening clothes in the laundry, deodorizing the
sink, and so on. The list of new reasons to use the product
encouraged customers who probably already had some baking
soda in their pantries to go out and buy more.

Product Development

• A product development strategy involves serving the same customer
base with new products. The advantage of using this strategy is
that you presumably already have a solid understanding of your
customers and serve them well with some offerings. You then use
that understanding to serve your customers through additional
products or services.

• These new offerings don’t necessarily have to be new to the
marketplace, though they can be. Often, they are just new to your
company. Many brand extensions are the result of following a
product development strategy.

• Consider Kellogg’s Special K brand of cereal. This product started
as a low-calorie alternative to sugary breakfast cereals, but the brand
now includes numerous other products, such as meal replacement
bars, snack bars, frozen waffles, breakfast sandwiches, and more.
All of these products are knit together under the aim of helping
people—primarily women—manage weight. In this case, Kellogg’s
customer base stayed the same, but new products were added to the
mix to better serve the customers.

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• The fast-food giant McDonald’s also executed a successful product
development strategy with the introduction of salads to its menu.

o In early 2003, McDonald’s suffered its first-ever quarterly loss.
Indeed, some store sales had been declining for 12 straight
months. The strategies the company had implemented to turn
sales around were not working. Some people thought the
solution was for McDonald’s to offer healthier food options,
but the company hadn’t had a successful new product launch
in 20 years.

o McDonald’s solved its problem and pulled off a remarkable
turnaround by looking for new ways to serve its existing
customers. The company discovered that many parents who
brought their children to the restaurants for a Happy Meal also
ordered one for themselves. Further, McDonald’s realized that
these adult customers weren’t being adequately served by the
restaurants’ offerings.

o In response, McDonald’s introduced a new line of “premium
salads” specifically designed to serve customers who were
already at the restaurants because of their children. After
introducing this new option, the average Happy Meal order
increased from about $5 to about $9. The “magic” here was
not in introducing a salad but in knowing exactly who the
customers were and what they valued.

Market Development

• Market development involves seeking out new customers
for a current product line. Like product development, market
development is typically more risky than market penetration.
After all, you are going after a new group of customers, whom
you probably don’t know as well as your current customers. But
the strength of a market development strategy is that you are not
developing radically new products. Market development means
selling essentially the same offerings to a new group of people.

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Lecture 53: Identifying Sources of Sales Growth

• Geographic expansion is one of the more common means of market
development. By opening a new store or office in a different
location, you are seeking to sell the same products or services to
customers who couldn’t buy them before.

• Often, new customers can also be found by re-segmenting the
market. New targets may then be chosen and small changes can
be made to the product line, repositioning the existing offerings to
serve new customers.

o In an earlier lecture, we discussed Levi’s pursuit of a
diversification strategy in the 1980s, when the company tried
to produce a new product—men’s suits—for a new group of
customers—the Classic Independents. As we saw, this strategy
failed for Levi’s; market development might have been a
better approach.

o At around the same time that Levi’s was developing its suits,
the market for casual jeans for women was largely untapped.
It was actually Lee Jeans that is generally credited with having
“discovered” this market. Levi’s was trying so hard to find
more exotic sources of growth that it missed a massive, low-
risk opportunity it was perfectly positioned to grasp.

Diversification

• Diversification involves trying to sell a new product to a new group
of customers. This is obviously the riskiest strategy because it
involves two entirely new and different sources of uncertainty.

• The upside of diversification is that, when done correctly, it can
vastly expand a company’s reach. Ideally, serving different groups
of customers, often in different markets, with a diverse set of
products, often from different price/quality tiers, and sometimes in
entirely different categories, can insulate a company from shocks
or changes in any one market or product category. A diversified
company tends to be a robust company.

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• The range of hotel brands promoted by Marriott International is the
end result of pursuing a diversification strategy. Each brand—from
the lower-end Fairfield Inn & Suites by Marriott to the high-end JW
Marriott Luxury Hotels—is distinctly positioned from the others to
serve a different group of customers.

Gap Analysis

• Gap analysis is a tool used to diagnose the source of a sales failure.
In other words, if you have a product or service on the market that
is not selling, you perform a gap analysis to help determine why.

• One type of gap analysis is performed to manage adoption, or first¬
time sales. This analysis starts with the largest group of potential
customers—your entire target segment. You then conduct market
research to work through a series of potential impediments to sales
and determine where the largest drop-offs are occurring. These are
the gaps, and they tend to be where it is most worthwhile to address
your efforts.

o Impediments to adoption may include awareness, understanding,
attractiveness, affordability, availability, and purchase intent.

o It’s important to conduct a gap analysis because each of these
impediments requires a different solution. For example, an ad
campaign designed to promote awareness must be different
from a campaign to foster understanding. Find the gap before
proceeding with a strategy.

• The other way to use a gap analysis is to examine repurchase. For
many products, success is not measured simply by the number of
people who buy the product for the first time but by the number
who continue to buy it. For this kind of gap analysis, you start with
purchase. In other words, the largest possible category is people
who have bought at least once. You then look at impediments to
repeat purchasing, which include satisfaction, usage frequency,
usage quantity, and repurchase intent.

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Lecture 53: Identifying Sources of Sales Growth

Suggested Reading

Chernev, Strategic Marketing Management, chapters 14-15.
Ansoff, “Strategies for Diversification.”

Questions to Consider

1. Use the Ansoff matrix to explore some opportunities for sales growth.
Pick one company in a market you are familiar with or that you
would like to become familiar with. Prepare a detailed strategy to
increase sales using each of the four categories identified by Ansoff:
market penetration, market development, product development, and
diversification. Consider the potential risks and rewards of each of
your solutions.

2. Perform a gap analysis on a product you are familiar with. In lieu
of conducting actual market research, use your intuition and make
some educated guesses about which impediments are probably most
significant in limiting both purchase and repurchase.

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Deriving Value from Your Customers

Lecture 54

A s we’ve seen in earlier lectures, both the customer and the company
must get something out of an exchange in order for it to be considered
a success. In the last lecture, for instance, we talked about the direct
value customers can provide to companies in the form of sales. But in this
lecture, we’ll think more broadly about other sources of value a company
should seek. In particular, we’ll cover three additional kinds of value that
customers can create for companies: loyalty value, information value, and
communication value.

Loyalty Value

• Customer loyalty is seen as a kind of philosopher’s stone by some
people in marketing. Loyal customers are widely considered to
cost less to serve and to be less price sensitive. They tend to buy
more and make purchases more often. They are also more likely to
forgive a company when it makes mistakes and to serve as brand
ambassadors. But the fact is that many of the purported benefits of
customer loyalty haven’t held up to empirical scrutiny. The link
between loyalty and its assumed benefits has often been difficult
to pin down.

• A part of the problem for researchers investigating loyalty is that it
is often operationalized in purely behavioral terms,
o Combing through your database, you might consider a
customer to be loyal if he or she has bought more than a certain
amount of your product within a certain time frame. Or if you
have retailer-level data, you might look at the people who buy
an especially high proportion of one brand relative to others in
a particular category.

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Lecture 54: Deriving Value from Your Customers

To be sure, you might generally expect a loyal customer to
buy more of your offering, but frequency, volume, and share
of purchase are not necessarily evidence of loyalty. It could be
that someone buys from you out of habit. Behaviorally, habitual
buying would look similar to loyalty, but psychologically, the
two behaviors are very different.

o Habits tend to be unthinking, unconsidered behaviors triggered
by external environmental stimuli. Perhaps entering the snack-
food aisle at the grocery store serves as a cue for you to buy
Triscuits. Loyal customers, in contrast, are more likely to view
an exchange with a company through the lens of a relationship.
They deliberately choose to buy an offering because they like it.

o In the normal course of events, habit and loyalty might look the
same. But if something changes to interrupt the cues—a store
rearranges its shelves or a customer moves to a new city and
faces new environmental cues—then the habitual behavior is
never triggered. Loyalty is more robust than habit. It is rooted
in a feeling that one offering is somehow superior to others.
Obviously, the differences in these types of behavior can be
significant for your business.

• For companies that are interested in fostering loyalty among their
customers, using the behavioral indicators found in their purchase
databases may not be the best place to start. Susan Fournier, a
marketing researcher from Boston University, is among a growing
group of scholars who study loyalty using the tools provided by
sociology and anthropology instead of those provided by statistics
and economics.

o By spending time with individual consumers and listening
to them talk about brands at length, these researchers have
discovered that customers use different language in discussing
the brands to which they are loyal. Specifically, loyal customers
talk about brands as relationship partners.

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The nature of these relationships is important because it affects
how customers think about their exchanges with the company.
The anthropologist Alan Fiske noted that people form different
kinds of relationships and that these different relationship types
color the way we engage in economic transactions.

o For example, a market pricing or market exchange relationship
is focused on maximizing economic value. This might be the
type of relationship you would have in the sale of a car to a
salesperson at a used-car dealership. In contrast, a communal
sharing relationship is focused on maximizing fairness. You
might have this type of relationship in the sale of a car to a
friend or a relative.

• The types of relationships people form with others have parallels in
the relationships people form with brands and companies, and many
of those brand relationships are based on market exchange. We
recognize the company as an entity out to maximize its utility, and
we enter the exchange seeking the same. But some of the exchanges
we have with companies or brands seem based to a greater extent
on communal sharing. Consider, for example, people who are loyal
to Apple products and tend to blame any computer problems they
have on software rather than the Apple hardware.

• For all these reasons, it is important to distinguish between loyalty
and its purely behavioral equivalents. In particular, think about
“loyalty” programs at many companies. These programs incentivize
repeat purchases, and many are successful at doing so, but are they
really generating loyalty? Would people continue to buy if the
“loyalty” rewards were eliminated?

o Of course, customer incentive programs can be powerful tools
to drive sales, but managers should not fool themselves into
thinking they relate to loyalty.

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Lecture 54: Deriving Value from Your Customers

Loyalty is different than incentivized sales; it is a potential
source of value for companies, and they should give careful
consideration to how much it is worth to cultivate a more loyal
customer base.

Information Value

• As many smart companies know, customers can provide you
with vast amounts of valuable information. For example, simply
by collecting aggregate and, increasingly, individualized data on
customer purchases, companies can get personal health information
on customers. This information can be used to customize offerings,
develop new offerings, and make more accurate forecasts.

• The information you can collect is not limited to sales data.
Requests for information or navigation patterns through your
website or physical stores can also teach you something about your
customers. Such information should be considered as a potential
source of value customers can provide—in addition to the money
they give you in an exchange.

• Further, customers can give you valuable information about your
own operations and marketing. A complaint from a customer may
highlight process failures, communication failures, or inadequate
company policies and procedures. It’s a good idea to assume that
every customer bringing you information—both positive and
negative—is speaking on behalf of several others.

• In many cases, you can hire a consultant to audit your processes
and procedures and give you good insights about how to improve
them. But you may also be able to get many of these insights for
free by simply listening to your customers—both the happy and the
unhappy ones. In other words, use your customers as consultants.

o One company that uses its customers in this way is Stew
Leonard’s, a small chain grocery store and dairy in the
northeastern United States. Although the stores have a
relatively small inventory compared to typical grocery stores,

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the chain has been called the “Disneyland of dairy stores.”
Costumed entertainers greet children in the aisles, and some
locations even feature petting zoos.

o But what truly makes Stew Leonard’s unique is the process
the store uses to find the ideas it implements on the sales
floor. Every store contains an oversized suggestion box, which
customers fill every business day. And every morning, a staffer
is assigned to type up the suggestions and circulate them to
the various departments around the store. Before lunch, every
member of the staff has a list of positive and negative feedback
items provided by customers. The company also holds regular
focus groups with customers.

o How well has this philosophy of listening to the customer
served Stew Leonard’s? The chain is in the Guinness Book of
World Records as having “the greatest sales per unit area of
any single food store in the United States.” It has also enjoyed
a consistent spot on Forbes’s list of the top 100 employers in
the country.

Communication Value

• Communication value is the value that customers bring to a company
by talking to other potential customers about the business—in other
words, customer word of mouth. Communication value stands in
contrast to the other types of value we’ve discussed because it is
often concerned with negative value.

• The communication value of customers is difficult to account for
because it is difficult to measure directly. But even though it is hard
to know exactly how much word of mouth affects your customers,
it is relatively easy to determine, in general terms, how important
word of mouth is likely to be to your company. You can start by
asking yourself some general questions about the type of market
you compete in and the type of customers you serve.

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Lecture 54: Deriving Value from Your Customers

o When determining how important communication value is to
your company, you should first determine the structure of the
market in which you are competing. Is it a competitive market,
one with many alternatives for customers to choose among? If
it is, then the opinions of consumers—both good and bad—are
likely to have a significant revenue impact.

Next, ask yourself about the
customers you serve. Some
customers are especially
likely to influence others
with their opinions, such
as those who have large
social networks, are leaders
in their communities, or
are skilled communicators.

Even if your target market
doesn’t seem to contain a

disproportionate share of influencers, you should still consider
the size of your overall target segments. In a large enough
group of customers, some of them will have the skills and
motivation to influence others.

If you sell to teenagers, then you
probably have many customers
with large social networks and
should be aware of the influence
of customer word of mouth.

You should also look at the types of goods or services you sell.
People are more likely to talk about some types of purchases
with their friends than others. For example, most people do
research when considering big-ticket items, and that research
may involve asking other people their opinions. Likewise, goods
and services whose quality is difficult to assess beforehand,
such as the work of doctors,
mechanics, and contractors,
are especially susceptible
to the effects of word-of-
mouth communications.

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Digital Vision/Photodisc/Thinkstock.

o Finally, ask yourself about the types of experiences your
customers are likely to have with your offerings—both the good
experiences and the bad. How typical are those experiences?
How easy is it for others to identify and sympathize with the
customer who had an especially good or bad experience?

Suggested Reading

Agarwal and Larrick, “When Consumers Care about Being Treated Fairly.”
Chernev, Strategic Marketing Management, chapter 5.

Fournier and Yao, “A Case for Loyalty.”

Questions to Consider

1. Consider the differences between loyalty and habit. Keeping in mind
that these two customer characteristics are often indistinguishable
using purchase data alone, how would you measure loyalty? What
tactics would you use to increase customer loyalty? In order to make
this exercise concrete, pick a specific product or service with which
you are familiar and define a specific target segment whose values you
understand. What could you do to increase the loyalty of this group for
this particular offering? How would you know if you were successful in
increasing loyalty?

2. Give some thought to the information value of customers. Consider your
company (or a company with which you are familiar) and generate a list
of concrete ways that company could make better use of the information
its customers provide. Think both of information about the customers
themselves (e.g., through purchase histories) and information about
the company (e.g., through complaints). How might this information
be collected more efficiently? How might it be analyzed in a timely
manner? What kinds of questions might this information answer?

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Lecture 55: Creating Great Customer Experiences

Creating Great Customer Experiences

Lecture 55

U p to this point, we have focused on marketing strategy. In particular,
we’ve looked at answering three all-important marketing questions:
Who are your customers? What do they value? How can you give
customers what they value better than the competition? We answer those
questions through the process of segmentation, targeting, and positioning
and by accounting for the various sources of value that customers and
companies get from an interaction. These are all strategic concerns, and as
we’ve said, strategy must come first. But once you have a strategy, you must
successfully implement it; this is the topic we will discuss for the remainder
of these lectures: the marketing tactics you can use to implement your
marketing strategy.

The 4 Ps and the Marketing Mix

• The most famous framework for remembering all the marketing
tactics you have at your disposal is the 4 Ps: product, price,
promotion, and place.

o Product refers to the offering itself—the attributes of your
product or service. In this context, product includes such
elements as branding, packaging, and warranties.

o Price is fairly straightforward, but again, in this context, it also
includes temporary discounts, such as sales and coupons, and
nonmonetary costs to the consumer, such as time, energy, and
attention required to buy the product.

o Promotion refers to all non-price factors involved in
incentivizing a purchase, such as advertising, sponsorships,
salespeople, and so on.

o Place refers to distribution. How does the product get to the
customer? Where can the customer buy the offering? Place
includes virtual locations, such as websites.

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• The 4 Ps were developed as a tactical framework by marketing
professor Edmund McCarthy in 1960 and have served marketers
remarkably well since that time. However, you should keep in mind
two words of warning about the 4 Ps:

o First, because of its popularity and history, some people
have come to treat the 4 Ps as if the framework encompasses
everything we need to know to solve marketing problems.
That’s not true! Always remember that the 4 Ps is a tactical
framework. You need a strategy before you can hope to use the
4 Ps well.

o The second danger in using the 4 Ps is remembering that this
framework also includes everything behind the four P-words.
To use the 4 Ps correctly, it’s not enough to remember what
the Ps stand for. You must also remember all the non-Ps that
are included in the four broad categories of product, price,
promotion, and place.

• A slightly expanded tactical model is based on the marketing mix
framework developed by Alexander Chernev in his book Strategic
Marketing Management. This framework includes seven basic
classes of decisions that marketers must make about their offerings:
product, service, brand, price, promotions, communication, and
distribution. Taken together, these seven variables are referred to as
the marketing mix.

The Customer Experience

• There are a few approaches to making tactical decisions about
products and services. One that has become popular involves
designing products and services to provide the best possible
experience for the customer. The basic idea is that customers’
evaluations of products and services are actually evaluations of
their experiences with the offerings—how it feels to buy, use, and
consume them.

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Lecture 55: Creating Great Customer Experiences

• Products and services are different in some important ways;
products tend to be tangible and separable from production, for
example, while services tend to be intangible and “consumed”
at the same time they are created. But focusing on the customer
experience blurs those differences. From a customer experience
standpoint, what matters isn’t whether the offering is a product
or a service but what the customer thinks and feels during the
interaction. In essence, the focus on customer experience means
treating every offering as if it were a service.

• To design products and services around the customer experience,
it’s important to understand how people evaluate experiences.
Consider, for example, your last vacation. A vacation is made up of
thousands of individual moments in time, but when it’s over, you
somehow end up with an aggregate impression of the entire trip.
How did you aggregate all those individual moments?

o Researchers have determined that there are two points in
time that overwhelmingly determine how we evaluate an
experience, whether it’s a phone call with customer service,
dinner at a restaurant, or a trip to Disney World.

o The first point is the peak, that is, the best, most enjoyable
point of a good experience or the worst, least enjoyable point
of a bad experience. The other point in time that matters is the
end—what you were feeling as the experience came to a close.

o When people look back on an experience and rate how they felt
about it—what psychologists call retrospective evaluation —a
simple average of the peak and the end predicts how they will
rate the experience as a whole.

o This finding is so robust that it has come to be known as the
peak-end rule , and it leads to several specific bits of advice for
managing customer experiences.

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Rules for Managing Customer Experiences

• The first rule for managing customer experiences is to finish well—
or at least less badly. Because the end is one of the two points in
time that matter the most, you want to make sure that it’s great.
Or if you can anticipate that the experience will be unpleasant for
your customer—a call with your service center to report a problem,
for example—do what you can to make sure that the end of the
experience is as good as you can reasonably make it.

• The second rule is related to the first: Get bad experiences out of
the way early. If there is any part of the interaction with a customer
that you know will be unpleasant, getting it out of the way early
reduces the likelihood that the worst part of the experience will
come at the end.

o For example, many firms acquire business by pitching their
services to prospective clients. And in many of these sales-
pitch meetings, the team explains all the benefits of the service
upfront and ends the meeting by revealing the price.

o But think about this approach from a customer experience
standpoint: Most of the good information is communicated in
the beginning, and the price—which is usually the client’s least
favorite part of the meeting—is saved for the end. The peak-
end rule suggests that clients may remember the experience of
the pitch meeting more favorably overall if the least pleasant
part were to come earlier in the meeting.

• The third rule for managing customer experience is to focus on the
peaks. If you are considering two ways of improving your customer
experience—one that will improve the average throughout the
experience and one that will make the best part just a little bit
better—you should choose the second. Improving the peak is more
likely to deliver an overall improvement in the customer experience.

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Lecture 55: Creating Great Customer Experiences

The fourth rule here is to consider the reference points. Experience
evaluations are often made relative to some reference point—some
expectation of how the experience should go. Your job as a marketer
is to determine what reference points your customer is likely to have
when evaluating your experience and, when possible, to influence
your customers’judgments by providing those reference points,
o One reference point that marketers can control is that established

by the company’s own communications. If advertising, social
media campaigns, and public relations messaging all paint a
picture of a magical experience, customers will take note and
set their expectations accordingly.

o Customers differ in terms of the expectations they bring to
market transactions. Therefore, one way of tackling the
tricky question of customer reference points is to treat it as
a segmentation and targeting problem. Are the customers

Recognize the level of service your customers are likely to expect based on the
category in which you are competing.

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you seek to serve especially discerning or well informed?
Then, they are likely to have high expectations, and you
should plan accordingly if you want to provide a great
customer experience.

o Another place to look for help in determining what your
consumers may use as reference points is the category in which
you are competing. Customers tend to evaluate experiences
relative to the environment in which they find themselves.
Some categories have a reputation for high product quality or
high levels of service, and customers will tend to expect more.

o A final bit of advice on using customer reference points
to anticipate customer experience is that reference points
reset. People tend to acclimate to what they have previously
experienced, and what was outstanding yesterday becomes the
minimum standard today.

• The fifth rule for managing customer experience is to segment
pleasures and combine pain.

o People tend to evaluate discrete experiences individually;
thus, when designing products and services, you should seek
opportunities to let your customers feel as many discrete happy
experiences as you can. For example, have your salespeople
introduce and demonstrate each benefit of the equipment
you’re selling one at a time, allowing potential customers to
absorb the information in discrete experiences.

o The opposite advice holds for bad experiences: Combine pains.
If you need to call a customer to explain a delay or a recall,
make sure to convey all the possible bad news at one time. If
you dribble out bad news over time, each new disappointment
will be felt as a fresh injury.

• The last rule for managing customer experiences is to motivate and
empower employees who will interact with your customers.

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Lecture 55: Creating Great Customer Experiences

o On the incentives front, make sure that employees are evaluated
on, and rewarded for, providing good customer experiences.
This may mean developing employee evaluation tools that
incorporate customer feedback as a metric. It may also mean
tracking, praising, and publishing internally examples of great
customer service. Make providing great customer experiences
a source of prestige within the organization.

o Once a culture of customer service is established, employees
will internalize that motivation, it will become an intrinsic part
of how your employees interact with customers all the time.

Suggested Reading

Chernev, Strategic Marketing Management, chapter 8.

Questions to Consider

1. Think about some recent purchases you have made and categorize
them as products, services, or some mix of both. Think about how you
could improve the customer experience associated with that offering.
In particular, are there any ways you might treat the products more like
services by focusing on the customer experience?

2. Pick a product or service with which you are familiar. Is there a way to
use the principles of reference points, the peak-end rule, and segmenting
pleasures and combining pains to improve the customer experience?

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The Tactics of Successful Branding

Lecture 56

B randing your offering is an important tactic, but it’s vital to keep in
mind that branding is only a tactic, and decisions about it should be
attempted only after you have a strategy in place. In other words,
you should not try to settle on any aspect of your brand until after you know
who your customers are, what they value, and how you plan to position the
offering so that it will provide superior value relative to your competitors. In
this lecture, we’ll define branding and look at how brands provide value to
the customer.

Defining a Brand

• One definition of a brand is practical and focuses on the branding
elements associated with a particular product or line of products.
Branding elements include some concrete features, such as the
product name, logo, slogan or tagline, a character or spokesperson,
packaging design, endorsements, sponsorships, and so on. Branding
elements can also include more abstract components, such as a
design aesthetic or guiding philosophy.

o This definition of a brand takes the company’s perspective.
Many companies have detailed rules about what can be done
with branding elements, including acceptable color schemes
and moderations that may be made to logos.

o This is a useful way of defining a brand, and every company
should know—internally—what elements are part of its brand.

• But this internally focused definition of a brand is not sufficient. We
must also consider what a brand is from the customer’s perspective.
Here, we can think of a brand as made up of structures in memory,
similar to a network with many individual nodes and connections,
o The nodes in this network are memories—feelings,
information, experiences, thoughts, and evaluations—that are
associated with the brand.

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o The nodes closer to the center are those that are more tightly
bound to the brand. Those farther out on the edges are
memories that are less integral and more transient.

• This definition of a brand as a memory structure makes it clear
that managing a brand is really about managing the associations
consumers store in memory related to that brand. Thus, establishing
a brand goes beyond just choosing a clever tagline. It means being
consistent and reinforcing important ideas repeatedly.

Case Studies in Branding

• Over the past several years, the office supply brand Staples has
sought to establish the idea of low prices in the memory structures
of its customers. Unfortunately, the “Easy Button” campaign run by
Staples earlier has been more long-lasting in the minds of customers
and seems incompatible with the idea of low prices.

o The positioning of Staples as the place to go to quickly solve
office supply problems was a good choice in the crowded office
supply retailer space. The “Easy Button” campaign conveyed a
simple message that provided a distinct source of value to a
particular group of customers.

o The problem arose when Staples tried to position both on
being easy—which suggests a high level of service and
convenience—and on having low prices. These ideas are in
conflict for most people.

o To the extent that Staples was successful in establishing a
node in memory linking the store to “easy,” it also probably
inhibited the link between Staples and “low prices.” By the
same token, if Staples is eventually successful in establishing
a memory structure linking the store to low prices, it may do
so at the expense of the easy message. Some links in memory
inhibit others.

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o Staples has also promoted its brand by sponsoring the Staples
Center, the basketball arena of the Los Angeles Lakers. This
sponsorship certainly gets the brand a great deal of attention,
but again, customers may associate the Lakers with glitz and
glamour, and these associations are inconsistent with the low-
price message.

o The Staples case highlights two lessons: (1) Be consistent, and
(2) when you encourage consumers to form an association with
your brand, make sure the association is something they value.

• NESCAFE, the first brand of instant coffee, serves as another
example of mistaken branding. When the product was first
introduced in the 1940s, it was advertised as a way for “housewives”
to take a break from their demanding chores and treat themselves
during the day. Unfortunately, women in the target market didn’t
associate the brand with relaxation but with slacking off.

o A research study published in 1950 showed that housewives
characterized women who bought NESCAFE as lazy, poor
planners, spendthrifts, and even bad wives!

o NESCAFE was successful in creating the mental associations
it had set out to create, but those were not the associations that
appealed to its target customers.

• When making branding decisions, keep in mind that you are trying
to manage the associations consumers form with your brand. Try
to reinforce those associations you want them to have and inhibit
those associations you don’t want them to have.

Branding and Customer Value

• In an earlier lecture, we discussed the four sources of value
for customers: functional, monetary, social, and psychological.
Functional value is accrued by virtue of an offering doing what it
was designed to do. Brands contribute to consumer evaluations of

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Lecture 56: The Tactics of Successful Branding

functional value by serving as signals. In economics, signal refers
to an easily observable but unimportant attribute that serves as a
proxy for a difficult-to-observe but important attribute,
o If you are buying a car, you want reliability, but that quality is
difficult to observe directly before purchase. Instead, we tend
to use brand as a signal of reliability because brand is an easy-
to-identify attribute.

o We know that Honda, for example, is a brand that tends to
be correlated with high reliability. Thus, brands influence
functional value by providing signals.

• Monetary value can also be influenced by branding. A brand sets
a reference frame for consumers when evaluating prices. If you
were to hear about a Bic pen selling for $50, you would probably
be shocked by the price. But if you heard about a Mont Blanc pen
selling for $50, the price might seem like a bargain. Even though
you don’t know anything about the pen other than the brand name,
the brand alone influences your evaluation of prices, thereby
affecting the monetary value you derive from the offering.

• How can you ensure that your brand serves as a signal to boost
functional value or as a reference frame to boost monetary value for
your customers?

o Both of these sources of brand value are based on correlations in

the minds of consumers: When your brand consistently produces
high-quality offerings or offers consistently low prices, those
links are reinforced in memory, and your brand’s signal value
is improved. But if you are not disciplined and consistent with
managing the brand associations your consumers form, your
brand’s signal value will be much weaker.

o In short, your brand must stand for something. And the way to
make that happen is the slow, regular, repetitive communication
of a consistent message.

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If you’ve ever bonded with someone over the sports team you both love, then
you've experienced the social value of brands.

• For social and psychological value, brands don’t serve as signals of,
or reference points for, another source of value. Instead, the brands
themselves create value for customers. Brands provide social value
by facilitating relationships with other people. In many situations,
the brand can serve as a kind of passkey that lets you into a clique
or group, as the brand Harley-Davidson does for owners of those
motorcycles. Brands can also provide an excuse to talk to someone
or serve as a topic for conversation.

• Brands can provide two types of psychological value: (1) internal,
affecting how we feel about ourselves, and (2) external, affecting
how we define ourselves to the world and influence others’
perceptions of us. Often, psychological brand value is referred to as
lifestyle branding-, brands that provide psychological value define
a lifestyle we are attempting to create and communicate to others.

o Again, the Harley-Davidson brand provides internal
psychological value to its customers by allowing them to
adopt a “tough guy” image. People who ride Harleys and wear
Harley jackets feel something different about themselves; they
actually become someone else temporarily by associating
themselves with a brand.

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Lecture 56: The Tactics of Successful Branding

o The Harley-Davidson brand also provides external psychological
value. Some people use the brand to communicate something
about themselves—perhaps a “wild side”—to others.

The Branding Ladder

• There is a common belief among marketing managers that it is
better to build a brand around psychological value than around
functional value. In fact, the sources of value are sometimes ordered
from the most concrete—functional value—through monetary and
social value, up to the most abstract value—psychological value.
This concept is known as the branding ladder.

• It is not difficult to think of successful brands that started as
functional brands but have moved up the ladder over time. Puma,
Swatch, Timberland, Patagonia, and Nike all initially positioned
themselves in terms of functional superiority relative to competitors
but, over time, moved into a space where they could serve as a
source of psychological value for customers.

• It is also easy to see why marketing managers view moving up the
ladder as a good thing. Functional attributes are more concrete and,
thus, more open to blatant attacks, while more abstract social or
psychological values are usually harder to make substantive claims
against. But it’s important to note that lifestyle brands are not as
unassailable as they might seem.

o To understand the potential downside of building a lifestyle
brand, we first have to understand why consumers would value
a brand that provides psychological value. The answer is that
lifestyle brands, just like other kinds of brands, create value by
meeting a consumer need. In the case of lifestyle brands, that
need is for self-expression.

o However, the need for self-expression fluctuates over time
and can be fulfilled in many ways. Customers can self-express
through brands but also through politics, hobbies, and so on.
Further, the need to self-express is not limited to a particular
product category. You do not have one need to self-express

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through your car, a separate need to self-express through your
clothing, and so on. The need to self-express is a single, unitary
need that can be sated in any number of different ways.

o Taken together, these three insights suggest that there are
some dangers to lifestyle branding. When moving away from
a functional positioning for your brand, you allow yourself to
serve a more fundamental consumer need, but you also open
yourself up to cross-category competition from any other brand
that is trying to serve the same need. You are no longer just
fighting for a share of the sales in a particular category but a
share of the consumer’s identity.

Suggested Reading

Chernev, Strategic Marketing Management, chapter 9.

Chernev, Hamilton, and Gal, “Competing for a Consumer’s Identity.”
Haire, “Projective Techniques in Marketing Research.”

Questions to Consider

1. Pick a brand that you like and list all the brand elements you can
identify—the logo, taglines, color palettes, spokesperson or character,
packaging design, and so on. Try to determine which elements are most
central to the brand. Which elements could be changed without affecting
how consumers thought about the brand?

2. Pick a brand (the same brand or a different one) and list all the
associations you have with it. Give yourself several minutes to free
associate. What memories, feelings, experiences, or people come to
mind when you think of this brand? Once you have created a long list,
go back through and rate each item in terms of how central it is to the
brand. Usually, the things you thought of first will be those you consider
most strongly associated with the brand. This rated list serves as a
representation of your memory structure of the brand.

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Lecture 57: Customer-Focused Pricing

Customer-Focused Pricing

Lecture 57

O ne of the most important decisions you will make in marketing is
how to price your product or service. Pricing is a tactic, however,
and like all other tactics, should not be decided until after you have
settled on a strategy. In other words, you should not attempt to price your
offering until after you know who your customers are, the specific sources
of value you seek to provide to those customers, and how your offering will
be differentiated from the competition. Assuming that you’ve addressed
these basic strategic questions, you can turn to the tactic of pricing. In this
lecture, we’ll look at several considerations related to pricing products
and services.

Pricing Information

• You need three basic types of information to set a price that will
jointly maximize value for both you and your customer. The first
piece of information is internal: What are the costs associated with
making and selling the offering? Cost information is important
because unless you have carefully tracked your costs, you could
end up accidentally selling your product at a loss.

• Even though cost information is important, when you consider
everything that goes into smart pricing decisions, costs are actually
among the least important bits of information you need. Cost
information sets a floor on what prices are possible for your firm,
but costs tell you nothing about how your customer will evaluate
your prices. Thus, the second type of information you need to price
your offering is your competitors’ prices.

o Keep in mind that the relative importance of competitors’
prices depends on the type of market you are in and the type of
product or service you sell. If you are in a market with many
competitors and it’s easy for your customers to compare prices,

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then keeping up with your competitors’ prices is extremely
important because your customer will almost certainly use that
information to evaluate your price.

o In contrast, if you are in an industry in which comparisons
are difficult or offerings are highly differentiated, then up-to-
the-minute tracking of competitors’ prices is less important in
determining your pricing strategy.

o When analyzing your competitors’ prices, you also need
to make sure that you use the right set of competitors. Your
competitive set should not be determined by any kind of
market designation, such as subcompact cars or liquid hand
soaps. It should not simply be the other brands in your category
as defined by major retailers or distributors.

o Instead, your competitive set should always be defined by your
customers. What other options will your customers use for
comparison when they are considering your product? If there
are certain brands in the same category that your customers
would never consider buying, then those brands are not in
your competitive set, and their prices are irrelevant. This also
means that your competitive set could span traditional category
markers if your customers consider options across categories to
be substitutes.

• The third and most important type of information to consider
when setting your price is the value your customers place on your
offering. Costs and competitors’ prices are important to know, but
ultimately, your goal is to price your products in such a way that
your customer thinks that what you are selling is worth what you
are asking for it. The most important lesson in pricing, then, is to
know who your customers are and to price according to the value
they see in your offering.

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Lecture 57: Customer-Focused Pricing

Pricing Variations

• At times, you may have more than one target group of customers,
and those groups may value your offering differently. What do you
do if one group is willing to pay $2 for your widget and another is
willing to pay only $1? If you want to sell to both groups, do you
have to set the price at $1 and leave the potential for extra money on
the table?

o Sometimes, the answer to this question is yes; you have to lose
out on that extra potential profit. But sometimes, it is possible
to identify barriers in the marketplace that differentiate target
customers according to when, where, or how they buy.

o Once you have identified those barriers, it is often possible to
charge two groups different prices for the same or substantially
similar products. This practice of charging different prices to
different groups is known as price discrimination.

• When price discrimination occurs over time, it is sometimes called
price skimming. Electronics companies frequently engage in this
practice. They know that there is a small group of customers who
want to be the first to have the latest technology. Thus, electronics
firms charge this group of early adopters a premium for getting a
new gadget first; they then slowly drop the price over time to appeal
to those who would like a bigger TV or a faster computer but are
not willing to pay a higher price to get it first.

Competing on Price

• Given the importance of price in driving consumer decision making,
firms often have a strong inclination to lower prices, but there are
several dangers associated with competing on price, including the
risk of inciting a price war.

o Some people seem to believe that there exists some magic
price point at which your price will be sufficiently lower than
your competitors’ prices that your customers will notice and
choose your product but not so low that your competitors will
react and lower their prices. The fact is that this magic price
does not exist. If your lower price drives customers away from

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your competitor to you, your competitor will react. And often,
the fastest, easiest response is to simply lower prices to match
your price drop.

o The only way to win a price war is if you have the lowest
cost structure in your competitive set. If you do, you can
sustain lower costs over the long haul. But if you don’t have
significant cost advantages, then trying to win on price is a
losing proposition. Try differentiating your product, focusing
on branding, or changing your distribution, but don’t compete
on price unless you have
an advantage on cost.

• One of the justifications for
lowering prices is to attract
new customers, but this
represents the second danger
of low prices: If you must
lower your prices to attract
customers, you are probably
failing somewhere else in
your marketing. You may not
have done your targeting and
positioning correctly,
o The experience of companies who used Groupons underlines
this point. With the Groupon service, customers sign up to get
periodic offers for significant discounts on restaurants, spa
treatments, and so on.

Essentially, when you lower prices
to attract customers, you are paying
customers to buy your product.

o Initially, many companies jumped at the chance to offer
Groupons and get new customers to try their products. But they
soon discovered that once customers took advantage of the
discounts, they never came back.

• The last danger of pricing low is the inferences customers make
about quality based on price. The fact that people tend to associate
lower-priced options with lower quality is well known, but not

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Lecture 57: Customer-Focused Pricing

many marketers realize just how powerful this tendency can be.
Research has shown that knowing the price of an energy drink can
influence how people rate a workout after consuming the drink and
even how well they perform on mental tasks.

• It’s also important to note that customers are often not nearly as
well informed about prices as many marketers assume they are.

o In one groundbreaking study, researchers asked shoppers in a
grocery store the prices of products they had just placed in their
baskets. Remarkably, even immediately after placing an item
in their carts, fewer than half the shoppers were able to report
an even somewhat accurate guess about its price.

o Some people have interpreted these results to mean that price
doesn’t matter—that consumers don’t pay attention to, or
care about, price. That’s probably not true, but there is reason
to question the assumption that consumers are always well
informed about prices.

Evaluating Prices

• Customers have two alternative paths for evaluating prices, the first
of which is to compare the prices of related items. For example,
customers may not know exactly how much a blender should cost,
but by comparing the prices of all the blenders on the shelf, they
can form an idea about whether the price of a certain blender is
attractive or not. This is known as using external reference prices or
the local context to evaluate prices.

o in managing context-based price comparisons, marketers need
to be aware of the general principle of extremeness aversion.
As a rule, consumers tend to avoid both the most expensive
and the least expensive options in a category.

o Marketers should also be aware that people tend to use the
context to gauge their preferences relative to other people. In
other words, if you’re shopping for binoculars, you might ask

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yourself how serious your bird-watching hobby is compared to
the entire population of bird watchers. Your answer will be a
factor in determining which pair of binoculars you buy.

o This tendency makes sense, but researchers have found that
people are not necessarily sensitive to overall prices when they
apply this rule. In other words, they are often too focused on
the prices of the local set they are considering.

• In evaluating prices, consumers also take into account price image,
that is, your reputation for pricing. Researchers have found that
when consumers don’t have a well-defined reference price for
a particular product, they assume that a price they encounter is
consistent with the retailer’s price image.

o For instance, when told the price of a carton of orange
juice from a high-end grocery store and from a store with a
moderate-price image, people evaluated the price differently,
even though it was the same in both cases.

o These results mean that a store’s price image should be
managed just like a brand image. In other words, price images
are not formed based only on a store’s objective prices. Rather,
consumers use many non-price cues when forming a price
image, including the store’s decor, its location, the level of
service provided, and so on. Price images are best managed not
just by managing prices but by managing all the price-related
associations consumers might form with a brand.

Suggested Reading

Chernev, Strategic Marketing Management, chapter 10.

Dickson and Sawyer, “The Price Knowledge and Search of Supermarket
Shoppers.”

Dolan, “How Do You Know When the Price Is Right?”

Shiv, Carmon, and Ariely, “Placebo Effects of Marketing Actions.”

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Lecture 57: Customer-Focused Pricing

Questions to Consider

1. Pick a product or service with which you are familiar. Think of two
different target segments to which this offering might appeal. Assume
that these two segments value the offering differently. What are some
ways that you could price discriminate, charging these segments
different prices according to their difference in willingness to pay?

2. Think about tactics you might use to avoid a price war. Imagine you are
managing some product or service and your major competitor drops its
price. What are all the ways you could respond to this threat without
lowering your price? How could you keep your customers and attract
new customers using other non-price tactics in the marketing mix? If it
helps, get specific: Think about a particular product and target segment
with which you are familiar.

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Marketing Communications That Work

Lecture 58

S ome of you may be surprised to find that we are discussing
advertising this late in the section on marketing. But the placement
of our discussion of advertising is a reasonable proxy for its relative
importance in marketing decision making. Because advertising is so visible,
many people mistakenly assume that it constitutes most of marketing,
but that’s not true. When marketing is done right, it starts well before any
particular communication program is even conceived. It incorporates
product design, pricing, distribution, and incentives—much more than just
advertising. With that said, communication is still important; thus, in this
lecture, we’ll talk about some of the principles involved in doing marketing
communications well.

Case Study: “Got Milk?” Campaign

• The process of communicating is interesting because it is a
microcosm of the marketing process itself. Just as you need a
marketing plan that includes a specific goal, a strategy to reach that
goal, and a set of tactics designed to implement that strategy, so
too, each communication effort requires its own communication

Only after you have a strategy in place does it make sense to start designing an
ad campaign, posting billboards, or sending out direct-mail catalogs.

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Lecture 58: Marketing Communications That Work

plan, complete with its own communication goal, strategy, and
tactics. We’ll begin by looking at these elements in one successful
ad campaign: the California Milk Processor Board’s “Got Milk?”
campaign.

• In the late 1980s and early 1990s, the per-capita consumption of
milk declined by about two gallons per year, which translated to
about $50 million in lost profit for the industry. As you can imagine,
milk producers were concerned and tried to diagnose the problem.

• Milk’s advertising in the late 1980s was targeted at children and
teenagers and delivered the message that milk was healthy—good
for strong bones, a great smile, and beautiful skin. This message
seemed to have gotten through. In survey research conducted
by the Milk Processor Board, 89% of respondents agreed with
the statement “Milk is a healthy drink.” Furthermore, a full 80%
reported that they liked the taste of milk. Why, then, were people
buying less of it?

o This question brings us to the first part of a communication
plan: Before you run any kind of customer communication
initiative, you should know the goals for your communications.
Are you running an awareness campaign, an information
campaign, or a persuasive campaign?

o The goal of your communication campaign should be
consonant with the larger goal of your overall marketing plan,
but it is usually more specific and targeted.

• The Milk Processor Board did some market research and found a
number of possible reasons for the decline in milk consumption, but
it zeroed in on the one problem that it thought could be addressed:
rationing. Because milk is usually purchased one gallon at a time
and shared across the household, consumption is highly sensitive
to how much milk is available on hand. The goal of the board’s
campaign, then, was to manage rationing by reminding people to
pick up milk every time they went to the store.

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• As we said, a campaign needs not just a goal but also a strategy.
And just like the larger marketing strategy, this includes a target
and positioning. In some cases, the target for a communication
campaign will be the same as the target for the marketing
strategy, but sometimes, the target is a subsegment of the total
target. Some popular products, such as milk, have several target
markets. A campaign could try to reach all those targets, or it could
communicate with just one of those groups. In the milk campaign,
the target was parents.

• There was also a positioning for the “Got Milk?” campaign in that
it promoted a simple message highlighting an advantage of milk
over competitive beverages. For this campaign, the Milk Processor
Board settled on milk as the perfect complement for other foods,
such as cereals, cake, cookies, and sandwiches. That was milk’s
value proposition.

• With a goal and a strategy in place for the communications
campaign, it was time for some tactical decisions. This is the
creative question: How can we get this message out to our target?
The tactics here included an award-winning series of “deprivation
ads”: In each ad, a person was shown enjoying some kind of
delicious food but discovered, too late, that he or she had run out of
milk. Each ad ended with the tagline “Got milk?” which served as a
warning not to let the same fate befall the viewer.

• The ads were a tremendous success. The campaign actually brought
about a 3% increase in sales, which translated into about $30
million. The ads were so successful in California, where they were
launched, that the National Milk Processors Board picked them up
and ran them nationwide.

• Unfortunately, the success was short-lived, possibly because the
campaign lost its focus. Instead of the message that consumers
should remember to buy milk, later ads promoted the health and

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Lecture 58: Marketing Communications That Work

beauty benefits of milk, returning to the message that had been
communicated in the 1980s. And the results were largely the same:
People believed the messaging but failed to buy the product.

Commanding Attention

• One of the keys to successful communications is to command the
attention of those watching or listening—and to do so without
turning them off. And one way to do this is to always have news.
If your commercials always inform customers of something
important—or, at least, something that seems important on first
glance—they are more likely to command attention.

• To ensure that you always have new information to share, you
might try the strategy of trivial innovation. Several beer companies,
including MillerCoors, have perfected this strategy. They don’t
change the recipe for beer, but they change other things about the
product, such as bottling or packaging, in order to have some bit of
news to promote in their ads.

• Budweiser gives us an example of a different strategy for getting
consumers’ attention. This company tends to not engage in as
much trivial innovation for its products and packaging; instead, it
produces ads that are destination entertainment and still promote
the brand well. Think of Spuds MacKenzie, the Budweiser frogs,
or the Wazzup?! guys. Budweiser creates cultural phenomena—
always carefully and closely tied to the brand—that people want to
watch and share with their friends.

Communication Templates

• One last thing to consider as you plan a communication campaign
is to give yourself room for evolution if the campaign gains some
traction. Even the best-loved ads get tiresome with sufficient
viewing. In order to keep people’s attention, it is often necessary
to change things up a bit or refresh the idea. Some campaigns
are flexible enough to do this in ways that hold true to the
original or current goals and are still different enough to keep
customers engaged.

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• The best way to allow for evolution is to establish a template for
communicating with your target customers instead of creating a
single piece or even a single set of communications. This advice
holds for all types of communications, including advertising, email
communication, direct-mail catalogs, PR campaigns, and so on.
When you establish the template, ask yourself: What about the
messaging is core and should remain immutable, and what should
be free to change over time?

• Among print advertisers, Absolut Vodka is perhaps the best
example of a company that does templates well. For years, its print
ads featured some visual variation on the iconic bottle, which took
up most of the page. The bottle could be made out of flowers, a
skyscraper, or mountains. Because the formula allowed for endless
reinvention, the ads never got old and always attracted attention,
while remaining consistent.

• An example of an ad campaign that seems to have evolved poorly is
the Capital One Visa card commercials.

o The original ads featured a barbarian horde descending on
a hapless credit-card user. The commercials delivered the
message that Capital One protects consumers from such
dangers as fraud, identify theft, and high fees.

o Over time, however, the focus of the campaign shifted.
Instead of being symbolic of the dangers inherent in modern
financial transactions, the barbarians became spokespeople
for the card. They charged items to the Capital One card to
rack up points to go on vacation or customized the card with
pictures of their barbarian children. None of this made sense
to the average consumer.

o The campaign evolved poorly because it didn’t follow a
template. Instead, it established a group of central characters
and simply let the wheels spin from there. From the customer’s
perspective, the result was confusing.

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Lecture 58: Marketing Communications That Work

Summing Up Communications

• Designing and running a marketing communication campaign can
be intimidating, but there is an established process. First, make
sure you have a goal for your communications, whether you are
designing a Super Bowl ad, a website, or a flyer. Ask yourself what
problem you want to solve with your communication.

• Your communications should also always have a target and a value
proposition. Sometimes, you will address your entire target or
multiple targets, but often, you will run an ad or other communication
effort targeted at just a subsegment of your entire target market.

• Only after you have a goal and a strategy for your communication
efforts should you start to think about the creative—the tactics for
your communications. The trickiest part of tactical communications
is the trade-off between entertaining customers and informing them.
If you fail to grab someone’s attention, it really doesn’t matter what
else you try to do in your communications. As we said, you can
attract attention by always sharing news or by providing people
with social currency—something they can talk about with friends.

Suggested Reading

Chernev, Strategic Marketing Management, chapter 12.

Questions to Consider

1. Watch some commercials. If possible, try to watch several ads from
the same campaign. (YouTube is a good source for this exercise.)
Then, reverse-engineer the decision process used to come up with the
campaign. What was the goal? Who were the target customers? On what
value proposition are the ads positioned?

2. Pick a brand you know well and sketch out a new ad for that brand. Start
with a goal—a specific problem you hope to solve with your ad—and
choose a target. Then, describe the creative you would use. How would
you grab attention without losing control of the message?

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The Promise and Perils of Social Media

Lecture 59

I n the last lecture, we talked about communications as a tactic. The
principles we discussed in that lecture hold for all your communications
efforts, whether traditional advertising, direct mail, or website design:
You should always know who your target customer is for any particular
communication effort, and you should customize your communication effort
to provide value for that customer. But even though these general rules apply
to all forms of communication with the customer, it’s also worth looking
at some of the nontraditional means of communication that marketers now
have at their disposal: social media, word-of-mouth campaigns, viral videos,
and so on. In this lecture, we’ll explore some of these innovative ways of
getting information to consumers.

Public Relations

• Nontraditional communications, such as social media, viral videos,
and so on, typically reach customers only indirectly—through
some intermediary, such as a reporter or a friend. As a result,
these nontraditional, indirect modes of communication effectively
add another layer of “customers” to be served. In this, they are
similar to one of the oldest and most well-established means of
nonadvertising communications: public relations.

• Not surprisingly, companies love public relations. After all, aside
from whatever you pay your PR firm or the person writing the
press releases, it’s free! Most companies attempt to take advantage
of PR by mailing press releases to the media, highlighting
company achievements and including quotes from executives
or customers.

• The problem with this approach is that companies often forget
who the “customer” is for their press releases. In the case of PR,
the press is the customer—reporters, cable news producers, and
industry trade writers. Far too many companies are completely

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Lecture 59: The Promise and Perils of Social Media

centered on themselves when they engage in PR efforts. They try
to tell reporters what the company is excited about, which doesn’t
interest the news media.

• If you want your PR to take off, you must give reporters something
they will be interested in writing about.

o For example, in the midst of an economic downturn, reporters
are probably looking for stories about “green shoots” in the
economy—evidence that business may be picking up. Instead
of sending out a generic story about your new product launch,
contact those reporters who would be most likely to write about
the economy and tell your story from that slant.

o Did your new product launch allow you to hire more people?
Do you plan to open a new factory that will create jobs?
Reporters will be interested in those kinds of hooks and are
more likely to tell your story to potential customers.

• One of the most astounding successes in recent PR history was that
of American Giant, a small, independent sweatshirt maker in San
Francisco. Instead of contacting fashion reporters, the company
sent a press release to Farhad Manjoo, a technology columnist for
Slate magazine.

o Manjoo was intrigued by the fact that American Giant used
the Internet to sell directly to customers from the factory,
bypassing the distribution costs faced by most apparel makers.
Fie also liked the idea that the company had hired an industrial
designer from Apple to assist in the design of the sweatshirts.
In December of 2012, he wrote a gushing tribute to both the
product and the company in a column entitled “This Is the
Greatest Hoodie Ever Made.”

o The column went viral almost immediately. It was tweeted,
emailed, posted on Facebook and picked up by ABC and
NPR. Within a very short time, American Giant sold almost
everything it had in inventory; it then took preorders for three
to six months in advance of delivery.

440

o The difference between American Giant’s astonishing PR
success and the deafening silence that most firms reap comes
from applying a basic marketing principle: Recognize your
customer. For PR campaigns, the reporter, columnist, or
producer is the customer.

Viral Marketing

• Viral marketing has been a common tactic for several years now.
The idea is to create something—an online video, a web game, a
clever tweet, an op-ed, or even just an experience or story—that
people will find worthy of forwarding or talking about to others.
Those others then push the content on to still others, and the
marketing message spreads, like a virus, until it has infected the
whole market.

• As you can imagine, getting viral marketing to work is easier said
than done. Most often, when companies or ad agencies announce
their intentions to start a viral campaign, they’re talking about a
communication effort that they are unwilling to fund.

• Like successful PR campaigns, successful viral marketing
campaigns must serve two customers or, rather, two sets of customer
needs. There must, of course, be the message about the product,
service, or brand—the marketing message. But there is also an
additional social need that must be met with the communication
effort. People need to derive some value from sharing the message.
That value comes from sharing content that is funny, emotionally
moving, profound, insightful, or just plain interesting.

• Just as you should anticipate the value that a reporter might seek to
gain from a press release, you should also know exactly what value
customers would get from communicating your would-be viral
message to others. Once again, the message of the company is often
not at all interesting to the customers whom you want to spread the
message. The key here is to give customers content that they will
want to give as gifts to their friends.

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Lecture 59: The Promise and Perils of Social Media

Destination Content

• Another change in marketing communication over the last few
years is the growing prevalence of destination content, increasingly,
companies are looking to cut through the clutter of advertising by
creating on-message content that people actually seek out.

• One version of this strategy is to create advertisements that are
so entertaining—funny, moving, or amazing—that people will go
online and look for the ads because they hear others talking about
them or because they want to see the ads again.

o One prominent example was a Volvo truck ad that featured
Jean-Claude Van Damme standing on the side mirrors of two
moving trucks. The trucks slowly drifted apart until the movie
star was doing a perfect split between two trucks rolling down
the asphalt.

o In cases like this, only a small fraction of the total viewership
comes when the ads air on television. Most of their reach
happens later, online, where customers seek out the advertising
content as destination entertainment.

• Such dual-channel advertising is not the only way to develop
destination marketing content. Increasingly, firms are creating
entertaining content that is designed for online viewing only.

o A prominent example here was a series of short films created by
BMW and distributed over the Internet. The films were written
and produced by top Hollywood talent and were praised by
TIME magazine and The New York Times.

o Because of the quality, these films became destination
entertainment. People sought them out, watched them, and
forwarded them to friends. The shorts were watched more
than 11 million times in the first four months after they
were launched.

442

• The blender manufacturer Blendtec has also created destination
entertainment but on a very low budget. Its “Will It Blend?”
webisodes feature the company’s founder putting various household
objects, such as a box of light bulbs, a six-pack of soda, or an
iPhone, into a blender.

o The short webisodes are bizarre, funny, and innovative. And
most important, they illustrate exactly how good Blendtec’s
products are at blending.

o Within a week of the first posting on YouTube, Blendtec’s
video had been viewed more than 6 million times. Within
two years, sales had gone up 700%. The campaign, which
involved no professional advertising firm and had practically
no budget, won a Clio award, one of the most prestigious
awards in advertising.

• Both BMW and Blendtec created value for the customer by
actually being entertaining. This seems basic, but traditional
advertising is primarily about delivering the message. That is
completely different from destination marketing, where the
entertainment value of the communication must be the primary
concern. If people don’t seek out your offering and tell their
friends about it, then it won’t matter what the message is. You
must create something worth seeking out.

o But just as an on-point message is useless without the
entertainment value to draw people in, creating something that
is entertaining without delivering the marketing message is the
same as throwing money away.

o What made both of these campaigns successful is that
they were able to entertain in a way that emphasized the
marketing messages.

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Lecture 59: The Promise and Perils of Social Media

Social Media

• As a communication tactic,
social media has several
advantages, including the fact
that it’s inexpensive. It’s also
a two-way communication
channel. If you pay attention,
you can learn as much from your
customers through social media
as your customers are learning
from each other. It is, thus, part
marketing communications and
part marketing research.

• Despite its advantages, however,
social media also carries the
potential for companies to
misuse it. One of the most
common errors, for example, is
the failure to base social media
strategy on the larger marketing
goals of the company. Many firms hire specialists to design and
implement their social media strategy, but often, these specialists
are removed from the rest of the marketing efforts. As a result,
their digital or social media campaigns don’t advance a company’s
overall marketing strategy.

o The clearest manifestation of this phenomenon is the obsession
with new metrics specific to various websites or platforms,
such as the Klout score or the number of Facebook likes.

o There is nothing wrong with getting people to like your brand
on Facebook; it opens a channel for further communication
with those customers and increases the chances that their
friends will see the association and become more interested in
the brand. But Facebook likes are not an end unto themselves.

444

The fact that they are easy to measure does not make them
appropriate metrics for a campaign—and is certainly not
justification for seeking them out.

• Another error companies make with social media is believing
that they must be a part of every new platform or forum for
communication. Such decisions should depend on whether the
target customers actually participate in a particular social media
platform and will be open to receiving company messaging on
that platform. You should always have your eyes open for new
opportunities, and if your customers are congregating in some real
or virtual space, you should try to be there. But virtual spaces are
just like real spaces, and your brand doesn’t necessarily belong in
all of them.

Suggested Reading

Chernev, Strategic Marketing Management, chapter 12.

Questions to Consider

1. Choose a product or service with which you are familiar, and think of
how that offering is positioned: What are its key selling points relative
to its competition? Using that key differentiator as a starting point, get
creative and brainstorm some content that is both relevant to the brand
and likely to be sufficiently entertaining that it will be shared and talked
about by customers.

2. Practice writing a press release that creates value for a particular type
of reporter. What are the needs of reporters in that field? How can your
press release help them meet their needs?

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Lecture 60: Innovative Marketing Research Techniques

Innovative Marketing Research Techniques

Lecture 60

I n these lectures, we’ve talked about strategy—knowing who your
customers are and what they value. We’ve also talked about tactics—the
mix of marketing variables, such as price, brand, and communication,
used to implement strategy. As we’ve seen, introspection and logic can
get you a long way toward creating a marketing strategy and developing
marketing tactics, but it’s also true that whenever possible, you should base
your decision making on solid market research. There’s simply no substitute
for talking to your customers and observing them as they buy and use your
products. Thus, we’ll end the marketing section of the course with the
activity that you will generally undertake first—conducting market research.

Qualitative Research

• Qualitative research methods include customer observations,
focus groups, ethnographies, and projective techniques. The data
produced from qualitative methods are most often expressed in
qualitative terms: stories about typical customer experiences and
representative quotes from customers. In general, qualitative
methods are useful for making new discoveries and reaching a
better understanding of customers.

• Some companies have a culture that embraces qualitative research
because they believe that these methods produce uniquely
useful insights. Consider Procter & Gamble’s official research
philosophy: “We live with our consumers and try to see the world
and opportunities for new products through their eyes. At P&G, the
CEO is not the boss—the consumer is.”

o The idea of “living with consumers” and “seeing the world
through their eyes” is what qualitative research is all about, and
you don’t get that by conducting some surveys or looking at
sales data.

446

o The goal of qualitative research is to shed all the baggage
that comes with working for a firm, of being involved in
marketing a product, of understanding all the behind-the-
scenes decisions that lead to an offering coming to market.
The idea is to put all of that aside and rediscover the offering
from the customer’s perspective.

• None of this is to say that qualitative research is superior to
quantitative techniques. Quantitative research and qualitative
research and are not substitutes for each other. The best scenario
is one in which marketers employ many different types of research
methods and use them iteratively, constantly looking for new
insights and testing those insights with additional research, before
starting over again.

• The goal of qualitative research is to develop a rich understanding
of your customers in situ , that is, as they shop, consume, and talk
to others about your offering. Some marketers refer to the output
of qualitative research as “thick descriptions,” which often include
direct quotes from customers. What you’re seeking is an accurate
representation of the experience of the consumer.

Focus Groups

• The most common qualitative research method used in marketing is
the focus group. This is a gathering of consumers, usually in groups
of 5 to 10, for a candid discussion of some topic, product, issue,
or political candidate. Typically, focus groups consist of only those
customers who are in the target segment.

• Focus groups have a discussion leader, who guides the participants
through a series of questions or tasks. If the group was convened
to discuss a product, there may be samples for the participants
to experience and react to. Historically, focus groups have been
held in conference rooms, often with a one-way mirror to allow
interested parties to watch the proceedings. More recently, it has
become common to conduct these groups in less formal settings or
even online, using video conference software.

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Lecture 60: Innovative Marketing Research Techniques

Quantitative research methods, such as surveys, have well-defined criteria that
must be met if the data are to be valid, interpretable, and generalizable.

• Focus groups are a good method for seeking clarification of some
particular idea or question. In this way, they are conceptually
similar to surveys. In both cases, consumers are asked a specific set
of questions to gain insight into a particular group of topics. Focus
groups are inferior to surveys in that the results tend to be less
generalizable, but they also allow marketers to get more in-depth
information from participants.

• Both surveys and focus groups are limited in that they are
primarily guided by the researcher. The marketer decides what
questions to ask and which topics to cover, which means that
surveys and focus groups tend to be bound by the limits of the
marketer’s imagination. It can be difficult to discover radically
new and surprising insights if you have to define all the questions
that will be asked in advance. Other qualitative research methods
are designed to get around this limitation by being more open-
ended and less directed by the researcher.

448

Customer Observation

• Customer observation is a fairly simple method of conducting
qualitative research. The advantage of using observation over
surveys or focus groups is that people aren’t always aware of their
behavior. If you observe customers, as opposed to asking them
direct questions, you can sometimes gain surprising insights.

o For example, a baby food company hired observers to
surreptitiously watch parents as they selected baby food in the
grocery store. Interestingly, the observers noticed that many of
the parents treated the jars of baby food as if they were fresh
produce, squeezing them, peering at them to look for bruised
spots, and even sniffing them.

o If the company had asked these customers how they chose
baby foods, they probably would have provided answers
related to fresh ingredients and good nutrition. None of the
parents would have admitted that they also squeeze the jars and
try to smell the contents through the lid because they probably
weren’t even aware of this behavior.

o The company used this qualitative research to redesign its
packaging. The jars were made to look rounder and more
organic, a bit like plums or apples, and the labels were made
smaller to make it easier for parents to see inside the jars.

• Observations can be done live, in stores or restaurants or on the
factory floor. Wherever your customers purchase or consume your
product or service, you can observe them. Many firms also apply
observational techniques to recordings of customer interactions.
For example, banks use recordings of interactions at ATMs to try to
improve customer experiences with the machines.

• One of the best-known proponents of observational research
methods in marketing is Paco Underhill, whose qualitative research
has resulted in a number of interesting observations about the way
people shop.

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Lecture 60: Innovative Marketing Research Techniques

o For example, Underhill found that customers generally require
a “decompression zone” when they enter a retail space.
Essentially, consumers are completely unaware of any signage,
displays, or special offers that are placed within the first few
feet of a store’s entrance. People seem to need a space to
become accustomed to being in the store. If you try to reach
them when they are decompressing, they will be blind and deaf
to your appeals.

o Another famous Underhill finding is the “butt-brush” effect.
Underhill found—not surprisingly—that people become
uncomfortable if other people or things touch their derrieres
when they are in public spaces. But retailers often set up
displays in high-traffic areas that require customers to lean
forward to examine the merchandise. Observation proved
that people tend to move away from these displays quickly to
avoid the possibility of “butt brushing.” Moving these displays
out of the flow of traffic allows customers to browse without
feeling exposed.

Ethnographies

• An even more interactive form of observational qualitative research
is ethnography. This is a research tool developed by cultural
anthropologists to understand the cultures, traditions, behaviors,
and beliefs of groups of people.

• The idea behind ethnographies is that we are all members of various
cultures that are alien to, and misunderstood by, those outside that
culture, including marketing managers and product designers. By
treating your customers as if they are members of an exotic culture,
you are free to ask a wide range of questions in order to see things
in a new light.

450

• Ethnography is also known as participant observation. In other
words, you are not merely observing the tribe of consumers but
trying to become part of that tribe yourself. Some companies, such
as Procter & Gamble and Harley-Davidson, embrace participant
observation for the insights it generates. Every year, top executives
at Harley-Davidson go on a three-day ride with Harley customers,
trying to actually live the experience of customers for a short
period of time.

Projective Techniques

• In addition to customer observations, focus groups, and
ethnographies, there are a number of projective techniques that fit
into the broad category of qualitative research. The basic theory
behind projective techniques is that sometimes people are guarded
when asked direct questions about a product, brand, or experience.
Asking indirect questions may reveal more about someone’s true
thoughts and feelings.

• Self-report biases are well-documented in studies that ask
people directly about their own preferences or behavior. Some of
these concerns can be reduced if you ask people to describe the
preferences or behavior of a “typical” consumer.

• You might also invite customers to clip pictures from magazines
and make collages that represent a particular product or brand.
You then examine the collages and ask what the images mean. The
collage becomes a springboard for discussing ideas and feelings
that the consumer may not otherwise be able to articulate. Data
collected in this manner may be harder to interpret but may also
present radically new findings.

• There are no rules for developing projective techniques. This is an
opportunity to get creative. For example, you might ask customers to
compare the product to an animal. Think of new and different ways
of getting people to project their opinions through indirect means.

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Lecture 60: Innovative Marketing Research Techniques

Companywide Marketing

• Many decisions made by people throughout a company—from
human resources to accounting to finance to operations—have
the potential to influence the value customers derive from their
interactions with the company. But if people outside of the
marketing department don’t know the marketing plan, what hope
will they have of making smart decisions? Marketing insights
should be infused throughout the company.

• Everyone in an organization should be able to answer the three
questions we’ve focused on throughout these lectures: Who is
the customer? What does the customer value? And how are your
company’s offerings differentiated from those of the competition?

• The crucial need for companywide marketing was summed up by
David Packard, cofounder of Hewlett-Packard: “Marketing is too
important to be left to the marketing department.”

Suggested Reading

Manzi, Uncontrolled.
Underhill, Why We Buy.

Questions to Consider

1. Practice observing customers. Choose an interesting site (a coffee shop,
a bookstore, a concert hall, or an aisle in the grocery story) and simply
watch people. See how they interact with one another and with their
surroundings. Look for commonalities among people. What are some
generalizable insights about customers in that setting? Could you use
your insights to make any marketing recommendations?

452

2. Participate in some market research. Look online for various companies
that allow you to participate in online surveys and focus groups. (You
may even get a little money for participating!) Your goal when taking
these surveys and participating in these focus groups is to learn as much
about the mechanics of the research as you can. What types of questions
are asked? How are the surveys or sessions organized? What was the
length? How did the survey start? What features of the research did you
like? Are there things you would have done differently? Now that you
have seen how other firms do research, shamelessly steal the techniques
and methods you think worked well and use them when designing your
own research.

453

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